Forex Investment and Currency Trading

Options, like futures, came into existence to help institutions and companies cope with increased fluctuations in the foreign exchange markets. Investors who buy options have the right, if they choose, to buy a specific amount of currency at a set price on or before a specific date. At its most fundamental level, an option is a choice.

Options are an effective hedging device against currency fluctuations. They allow a buyer to lock in an exchange rate and then use the option only if the situation warrants. They buyer, however, must pay a premium at the outset for an option.

A good way to understand options is to read a legend about their first use. An ancient Greek philosopher, Thales of Miletus, grew sick of jibes that he was a poor man. Thales insisted he was poor because he chose to be, and one year he decided to prove it. That year, Thales determined from the weather patterns that the olive crop would be especially large. In the off-season before the harvest, Thales went to the olive press owners and offered a deal. He would pay them a small amount in advance for the exclusive right to operate their presses during the harvest if he wanted to. If he didn’t use the presses, the press owners could keep the advance. If he did, the press owners would receive the guaranteed rate. The press owner liked the idea, Thales’ prediction was correct. The olive growers reaped a bountiful harvest, and when they went to rent presses, they found that Thales controlled them all. He could charge whatever rate he wanted to. Using an ancient version of options, Thales had demonstrated that he could be rich if he wanted to.

Options, like every other foreign current transaction, involve a person who is buying a currency and another who is selling it. The right to buy a currency is a call option, and the right to sell it is a put option. Each option is both a call and a put. Therefore, an option to buy euros and sell U.S. dollars is a euro call and a U.S. dollar put.

Investors who use options tend to be institutions that rely on stable currency exchange rates to operate. This includes banks, multinational corporations, importers and exporters, and investors in foreign stock exchanges. On the other side of the deal are speculators who, as they do in futures, assume risk I the hopes of marking a profit.

Options provide investors with a relatively cheap way to hedge themselves against risk when trading foreign currencies.

The two parties in very option transaction are the buyer and the seller, or writer. In a typical option contract, the buyer agrees to pay or sell a certain amount of currency at a guaranteed price – called the strike price or exercise price – if the buyer chooses to.

The principal is the amount of currency that can be bought or sold under the contract.

Each option applies for a specific period of time before the expiration (also called expiry) date. In American-style options, the buyer can exercise his right to the option on any business day up to and including the day the option expires. In European-style options, the buyer has the right to exercise the option at any time, but the currency is delivered on the expiration date.

To buy an option, an investor must pay the premium. If the investor does not exercise the option, he or she loses the premium.

The premium price varies, depending on how likely the market believes the option will be exercise. For example, some premiums are simply the difference between the current spot price and the future strike price. Others use complicated formulas based mostly on current market conditions and the time before the option expires. Options are bough, sold, and resold as the market changes. Typically, however, less than 20 percent of options are actually exercised at the expiry date.

Options typically can be bought in two different settings – on an exchange or in interbank (also called over the counter OTC). Exchanges generally standardize their options, setting the strike price, the contract size, and the expiration date. They typically offer American-style options. Options offered on the interbank market can vary, because the buyer and seller can negotiate specific points before making a deal. These options tend to be in the European style.

The Chicago Mercantile Exchange (CME) is one of the major exchanges where currency options can be traded. It offers standardized and customized options, although primarily only in the currencies of strong economies – the U.S. dollar, the euro, the yen, the Australian dollar, the Canadian dollar, the British pound, and the Mexican peso.