Forex Options

An option is a contract which gives the holder the right, but not the obligation to buy or sell the underlying commodity. Forex options are often used for reducing risk, particularly by companies which trade goods overseas.

There are various types of Forex options, but the most common are Call options and Put options. Call options give the holder the right to buy a particular currency, while Put options give the holder the right to sell a currency.

This right to buy or sell can be exercised anytime before the Forex option expires. At the time of expiration, the option only has value if it can be exercised at a profit.

At any time before the expiration date, the Forex option may have intrinsic value which is calculated according to the spot price (current price) of the currency as well as the strike price - the value specified by the option contract.

A call option only has intrinsic value if its spot price is above the strike price, and a put option has intrinsic value if the spot price is below the strike price.

Forex Options in the Money

If a Forex option has intrinsic value it is said to be "in the money." Otherwise, it is "out of the money" (no value) or "at the money" (at par).

Forex options are priced according to both the spot value and the time value. The time value is calculated by a complex formula which takes into account expected market conditions and the difference in interest rates between the two currencies.

Forex options must be priced so that they are attractive to both buyers and sellers. Risk to buyers is limited to the cost of the Forex option, but the risk for sellers is potentially unlimited if the market moves against them.

Forex options are primarily used as a hedging tool by companies trading overseas. A Forex option can minimize the potential for loss due to changes in the currency exchange rates.

Digital Options

A special type of Forex option is the Digital Option. This type of option specifies a payout if currency prices reach a predicted level. If the currency prices do not move as expected, the Digital Option pays nothing and the Forex investor loses the cost of the option.

Anyone wanting to buy a Digital Option must first decide whether the market is moving up or down, and then choose a payoff amount if the market reaches a specific level within a specific timeframe. These three factors are used to price the digital option.

As an example, if EUR/USD is trading at 1.2900 and you expect it to rise to 1.3300 within two months, you may buy a digital option with a payoff of $2000. The cost of this option is $400.

At the end of two months EUR/USD is trading at 1.3305 so you get $2000. If it had been below 1.3300 you would have lost $400.