April 29th, 2017
Learning about forex options is crucial in understanding how the foreign exchange market works. A currency option is a contract that gives the holder the right to buy or sell the currency during a specific period of time, though they are not obligated to do so. The specific price that the currency is to be sold at is referred to as the strike price, and the specific date that it should by sold by is called the expiration date. The amount that the option buyer pays to the option seller is called the premium.
There are two basic types of options, they are call options and put options. Simply defined a call option gives the trader the right to buy, while the put option gives the holder the right to sell. It is important to note that on the foreign exchange market for every put buyer there is a call seller.
At its expiration, the option is equal to the value realized by the holder in exercising he option. If the holder of the contract does not gain anything then the value of the option is nothing. The value of the option during any other time other than its expiration is called the intrinsic value.
The intrinsic value of an option is the difference between the strike price and the current or spot price. This is the value of the option if it is exercised. The intrinsic value of an option on the forex must be zero or above. An option with no intrinsic value would be at zero, and would be considered out of the money. Options with intrinsic value are said to be in the money. These options have a spot price below the strike price.
The extrinsic value of an option is referred to as the time value. It is defined as the value of a foreign exchange option beyond its intrinsic value. The biggest factors in determining extrinsic value are the volatility of the two spot currencies, the strike price, the time left until expiration, and the interest rate of both currencies. As the expiration date gets closer, the extrinsic rate diminishes.
An option is priced according to a formula that takes into account the spot value and extrinsic value. Options need to be priced low enough to attract buyers, but also low enough to attract option sellers, or writers.
The delta is the change in price of a foreign exchange option compared to a change in the spot or current rate. The delta falls between zero and one. The closer the delta is to one the closer the strike price is to the spot rate.
Options are commonly used in the foreign exchange market to minimize risks. This is because the investor that buys options risk only what they paid for it. However, option sellers are subjected to unlimited losses if the market moves unexpectedly.
For this reason options are commonly used as hedging tools. Companies that specialize in international trade will use forex options to minimize their potential loss due to sporadic changes in the market.
Foreign exchange trades have a unique option referred to as the Digital Option. This special option will pay the holder a specific amount of money at expiration if all the criteria are met. If the criteria are not all met nothing will be paid.
The forex option market is increasing immensely. Currently, it includes a growing number of individuals, brokers, companies and banks. These members can participate via the telephone or numerous online trading platforms. They can use options to make profit or simply to minimize risks.