An FX option provides you with the right to but not the obligation to buy or sell currency at a specified rate on a specific future date. A vanilla option combines 100% protection provided by a forward foreign exchange contract with the flexibility of benefitting for improvements in the FX market.
This works like an insurance contract. In exchange for such a right (without the obligation), the holder usually pays a cost which is known as the Premium for the FX Option.
Currency market fluctuations can have a lasting impact on cash flow whether it is buying a property, paying salaries, making an investment or settling invoices. By utilising FX Options, business can protect themselves against adverse movements in exchange rates.
This feature of FX Options makes them extremely useful for hedging FX risk when the direction of movements in exchange rates is uncertain.
FX Options are also useful tools which can be easily combined with Spot and Forward contracts to create bespoke hedging strategies. FX options can be used to create bespoke solutions and work to remove the upfront cost of a premium – this involves certain caveats around the structure of the option product.
Basic terminology for FX Options
Premium – The upfront cost of purchasing a currency exchange option.
Strike Price – The strike (or exercise price) is the price at which the option holder has the right to buy or sell a currency.
Expiry Date – The trade’s expiry date is the last date on which the rights attached to an option may be exercised.
Exercise – The act of the option buyer notifying the seller that they intend to deliver on the option contract.
Delivery Date – The date when the currency exchange will take place, if the option is exercised.
Types of Currency Exchange Options Contracts
Depending on the underlying transaction, FX options may be classified as:
Call Option – This gives the holder the right but not the obligation to purchase a specified currency at a pre-arranged rate up to the expiration date.
Put Option – This gives the holder the right but not the obligation to sell the specified currency at a pre-arranged rate up to the expiration date.
FX options can also be classified based on the timing for exercise:
European Option – European options can only be exercised at the end of the agreed tenor (at maturity).
American Options – American Options can be exercised any time during the life of the contract.
In Britain, spread betting and CFD providers offer FX Options products, but their popularity pales into insignificance compared to the gigantic CFD businesses that are the de facto trading environment in Britain, which is interesting because a CFD is a type of OTC futures contract in itself.
The interesting matter with regard to measuring the popularity of FX Options in the US compared to elsewhere, is that the figures that are available from each executing venue or brokerage are completely accurate because they are often executed through a centralized exchange (certainly in the case of the US entities).
With regard to measuring OTC products, this is a deal harder due to the various methods which privately listed companies use to measure volumes.
Finally, a move toward FX Options may be a means of mitigating the proposed rulings on CFDs and other leveraged products by British, German and Cypriot regulators, a decision on which many senior executives in the FX industry hold an opinion that it was brought about by a lobbying effort from the listed derivatives sector which is seeking to push the OTC derivatives sector onto exchanges.
If the recent mergers and acquisitions interests by various European exchanges which were highlighted by FinanceFeeds in a very detailed reportrecently is anything to consider a measure of that dynamic, FX Options may be the way to go.