The Advantages of Currency Options

An option is a nonbinding, or optional, agreement to buy or sell something at a fixed price on a future date. Options that entitle you to a fixed purchase price are referred to as call options, or simply "calls." Options that lock in a fixed sale price are called "puts." When working with currencies, you are paying one kind of money to buy another denomination, essentially exchanging money for money. It can be confusing in the beginning to know what currency is being bought and what is being sold. When trading currency options, focus on how much of which currency you will surrender and how much of another currency you will obtain if you elect to make the trade.

Options can be an excellent hedging instrument. Hedging refers to mitigation of risk arising from holding a financial asset. Assume you have $100,000 and may have an expenditure in six months that's payable in euros. To avoid the risk of having to convert the dollars to euros at an unfavorable rate in six months, you can purchase an option that gives you the right to give up $100,000 and obtain 85,000 euros in exchange in exactly six months. If the exchange rates move in such a way that you can get a better deal than that by simply using your local bank to convert dollars to euros, you can ignore the option.

Currency options give you the opportunity to engage in relatively large trades while investing little money upfront. When you purchase an option to exchange 10,000 British pounds for $15,000 in a month, you will pay a sum that is far less than 10,000 GBP or $15,000. Such bets are used by traders who believe that one currency will appreciate against another. If, in a month, you can purchase 10,000 GBP for only $14,000, you can use your option to exchange the pounds you have just bought for $15,000 and pocket a cool $1,000 in profits. If you paid less than $1,000 to buy the option in the first place, you will be left with a net gain.

The two types of options are OTC, or Over the Counter, options, which change hands between private parties, and exchange-traded options, which trade in public options markets. Novice investors should stick to exchange-traded options, as these are far more liquid than their OTC counterparts. Liquidity refers to the ease with which you can locate the exact financial security you are interested in buying or selling. You can buy exchange-traded options with minimal trading costs and commissions, and should you change your mind, you can usually sell them anytime before the expiration date. Counterpart risk -- the probability that the other party who is obliged to take one type of currency from you and deliver another will fail to do so -- is also minimal with exchange-traded options.