Experiences With Currency Options Trading

Currency options are used to speculate on the direction of the market.

Currency options are derivative products that allow investors to speculate on either the direction of the currency market or movements in the currency markets. Currency options also allow commercial entities the ability to hedge their currency exposure. They are also leveraged products and investors should be aware that with leverage, both gains and losses can be magnified.

Definition

A vanilla currency option is either a call on a specific currency pair, or a put on a specific currency pair. A currency pair and its associated exchange rate is the value in which one particular currency can be exchange for another. For example, the current euro/U.S. dollar exchange rate is 1.45. This means that for every one euro, and investor would need 1.45 dollars to purchase that euro. A call option on a EUR/USD currency pair is the right but not the obligation to purchase the currency pair at a specific price, which is called the strike price, on a specific date, which is called the expiration date. A put option on a currency pair is the right, but not the obligation, to short (sell) a currency pair at a specific price on a specific date. To purchase an option on a currency pair, an investor will need to pay a premium. A premium is an amount paid to the option seller for the right to buy or sell an option.

Speculation

Currency options are generally used to speculate on the direction of the market. The benefit to using a call option to speculate on a currency pair moving higher, or buying a put option to speculate on a currency pair moving lower, is that an investor will cap his losses at the amount of premium he has paid for an option. If an investor sells a currency option without hedging the transaction, the risk to the investor is unlimited. On a sold call option, if the market rises, the investor will need to buy the call back to mitigate her risk. The reverse is true for a sold put option.

Hedging

Commercial entities will use currency options to hedge their currency exposure. An example of why they transact a currency options is as follows. If a treasurer of a company located in the United States potentially needs to purchase Canadian dollars at a time in the future, but is not sure about the timing, he could buy call options on the Canadian dollar to ensure that he has eliminated upward movement in the currency before making his decision. The maximum loss is the premium paid for the currency option. The treasurer will eliminate the risk of the Canadian dollar moving higher until he is sure about the timing of his hedge.

Volatility

Another way currency options are used to speculate is to bet on large market movements in a currency pair. By purchasing a call and a put at the same time, an investor is speculating that the market will move in one direction or another in a short period. The market movements will need to make up for the premium needed to pay for both the call and the put for this strategy to be considered successful. This is called volatility trading.

Conclusion

Option trading is extremely volatile, and it is difficult to earn money trading currency options unless you have studied the different assumptions that make up the pricing of options. In general, options are priced to incorporate how much the market believes the underlying currency pair will move before expiration. To be successful, the market will need to move more than this implied amount on purchases of options, and less than that amount for sales for an investor to be successful.