Currency options and futures are both derivative contracts – they derive their values from the underlying asset -- in this case, currency pairs. Currencies always trade in pairs. For example, the euro/U.S. dollar pair is denoted as EUR/USD. Buying this pair means going long, or buying, the numerator, or base, currency --the euro -- and selling the denominator, or quote, currency -- the dollar. If you sold the pair, these relationships would be reversed. You make money when the long currency appreciates against the short currency.
Foreign Currency Futures
Currency futures oblige the contract buyer to purchase the long currency and pay for it with the short currency. The contract seller has the reverse obligation. The obligation comes due on the futures expiration date, and the ratio of bought and sold currencies is agreed to in advance. The profit or loss arises from the difference between the agreed price and the actual price on the expiration date. Margin is always deposited for futures trades – it is cash that acts as a performance bond to ensure both parties fulfill their obligations.
Options on Currency Pairs
The buyer of a currency pair call option may decide to execute or to sell the option on or before the expiration date. The option has a strike price that denotes a particular exchange ratio for the pair. If the actual price of the currency pair exceeds the strike price, the call holder can sell the option for a profit, or execute the option to buy the base and sell the quote on profitable terms. A put buyer is betting on the quote currency appreciating against the base currency.
Options on Currency Futures
Instead of having an option to buy and sell currency pairs, an option on a currency future gives holders the right, but not obligation, to buy a futures contract on the currency pair. The strategy at play here is that the option buyer can benefit from the futures market without putting down any margin. Should the futures contract appreciate, the call holder can simply sell the call for a profit and need not purchase the underlying futures contract. A put buyer profits if the futures contract loses value.
Differences between Options and Futures
The main difference is that option buyers are not obligated to actually purchase or sell the long currency – futures traders are. Option sellers may have to buy or sell the underlying asset if the trades go against them. Option buyers need not put up any margin and their potential loss is limited to the purchase cost, or premium, of the option. Option sellers and futures traders must put up margin and have virtually unlimited risk. Finally, the premium of an options contract is almost always lower than the required margin on a similar futures contract.
References
Resources
- "Currency Trading in the Forex and Futures Markets"; Carley Garner
- "Options on Foreign Exchange"; David F. DeRosa
- "Foreign Exchange: A Practical Guide to the FX Markets"; Timothy M. Weithers
Writer Bio
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.