What is a currency option?

• A currency option is a derivative product

• Currency options grant the right to buy/sell a currency at a predefined price within a specific timeframe

• Currency options provide a way to hedge against potential currency fluctuations

• The main arguments in favor of currency options are a high degree of flexibility and limited loss potential

• The cost of a currency option can be high 

In forex trading, we talk about currency options, which have the same general rules as any other option: the holder of a currency option has the right to buy or sell currencies at a given exchange rate and within a specific timeframe. The value of a currency option is derived from the value of the underlying currency pair. 

There are two types of currency options: 

• call options and 
• put options.

A call option gives the holder the right to buy the underlying currency at a predetermined exchange rate within a specified timeframe. A put option gives the holder the right to sell the underlying currency at a predetermined exchange rate within a specified timeframe.

Here is the basic terminology you need to know in order to understand currency options:

• Spot rate -  this is the current exchange rate on the market
• Strike price - the price at which the option can be exercised 
• Premium - the price paid by traders for put or call options 
• Expiration date - the timeframe of the contract  
• In the money - if the strike price is more favorable than the spot rate
• Out of the money - if the strike price is less favorable than the spot rate. In this case the holder will typically not exercise his right to buy/sell the currency. 

The price of a currency option is impacted by the following factors:

1. spot exchange rate
2. interest paid on the sold currency 
3. interest paid on the purchased currency 
4. contract price of the option
5. remaining time until the option expires
6. volatility of the exchange rate in the period between the conclusion and expiration of the option

Currency options are traded on various exchanges and are a helpful tool for hedging against currency risk or for speculative purposes.

Currency options are used by companies as well as traders and investors to manage risks associated with currency fluctuations, allowing them to lock in a price for future currency transactions. Read on for a real life example of how currency options work in practice.

Currency options have advantages and disadvantages in forex trading. See the following table for the most important arguments in favor and against currency options. 

If you are a beginner, we recommend you open a demo account at a forex broker and trade with virtual money at first until you develop your own trading strategy. Most of the brokers in our top list of the best forex brokers in the world provide a demo account free of charge. 

Let's say that a US company wants to purchase goods from another company in Europe in six months. The US business is concerned that the euro may strengthen against the US dollar during that time, making their purchase more expensive.

To hedge against this risk, they decide to purchase a currency option. The US company decides to purchase a 6-month call option, which gives them the right to buy euros at a strike price of 1:1.18 (1 euro to 1.18 US dollars). They pay a premium of $5,000 for the option. 

If the euro weakens against the US dollar over the following six months and the EUR/USD exchange rate is 1:10, the US company will not exercise the option and will purchase euros at the spot rate. In this scenario, the company will have lost the $5,000 premium paid for the option. 

However, if the euro strengthens against the US dollar and the EUR/USD exchange rate reaches 1:1.25, the company will exercise the option and purchase euros at the strike price of 1: 1.18. In this scenario, the importer saved money by purchasing euros at a lower exchange rate than the current spot rate.

What are currency options and their types?

There are two types of currency options: calls and puts. Buying a call option gives the holder the right to buy a currency pair at the strike price on or before the expiry date, and buying a put option gives the holder the right to sell a currency pair at the strike price on or before the expiry date.

What is an example of a currency put option?

In a put option, the buyer has the right to sell a currency pair at the strike price. A trader would buy a EUR/USD put option if he thought the USD would rise in value against the EUR. The potential profit would be unlimited in this case while losses would be limited to the options premium. 

How is the currency option calculated?

Let's assume the current forward rate is 1.17 and you are the holder of this option: put EUR 100 million, call USD at a strike of EUR/USD 1.18 for expiry 15 December 2023. Intrinsic value = EUR 100M * (1.18–1.17) = USD 1M.