Understanding FX Options
FX options, also Forex options or currency options, are a type of options contract whose underlying asset is the exchange rate between two specific currencies. As with other options contracts, FX options are available in several varieties. Two of the most popular FX options are traditional options and binary options. As investment tools, FX options may be used speculatively as a trading tool or as an instrument for hedging exchange rate risk.
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What Does FX Mean?
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FX is an acronym which stands for "foreign exchange" and refers explicitly to the international market for the exchange of the world's currencies: the foreign exchange market. This market is a globally connected network of currencies brokers and traders. With roughly $1 trillion worth of trades placed on any given day, the foreign exchange market constitutes what most consider to be the most liquid market in the world. From a practical standpoint, this market allows for the exchange of goods and services across national borders. For many investors, it represents a lucrative opportunity for short-term gains via speculative trading.
What Are Options?
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Options are financial derivatives which constitute an agreement between two parties who disagree about the future direction of the price of a specific market asset. For instance, if an investor (buyer) believes an asset's market price will rise, he or she purchases, for a premium, a call option from another investor (writer) who believes the market price will decline. If the market price declines, the buyer receives no payment, and the writer retains the premium he initially received from the buyer. By contrast, if the market price rises, the writer must sell the buyer units of the underlying asset for the lower price specified in the option. The logic follows that the buyer may then profit from selling these units in the market for the higher price. The buyer has the right to execute the terms of the option contract, but is not obliged to do so. To this extent, the writer is obliged to fulfill the option only if the buyer chooses to execute its terms.
What Is the Difference Between Call Options and Put Options?
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All options principally fall into one of two categories: call options and put options. Call options, as described earlier, are written by investors who foresee a decline in the price of an asset. For this reason, they are a suitable instrument for buying investors who foresee a rise in the price of an asset. By contrast, put options are written by investors who believe an asset's price will rise. Consequently, put options are a suitable choice for buyers who believe an asset's price will fall.
How Are Options Structured?
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Though options styles vary, all options contain a number of elements which determine an option's premium, payoff and interim market value. Option contracts are written based on a market-traded asset called the underlying asset (for example, a stock). The option contract delineates a specific price, called the strike price, above which the market price must rise (call options) or below which it must fall (put options) to have value for the buyer. The expiration date provides a time frame during which the speculated price movement must occur. For many option contracts this date determines the option's value. Beyond the expiration date, an option contract terminates and becomes worthless.
What Qualify as FX Options?
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FX options are option contracts which use a specific market exchange rate as the underlying asset. This exchange rate is made up of two currencies, one of which is almost always the currency in which the option contract is denominated (for example, U.S. dollars). The strike price in a FX option is a definite level for that exchange rate (for example, $1.70 per £1). The value of the option contract depends on the behavior of the market exchange rate with regard to the strike price (strike "rate").
What Are Traditional FX Options?
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A traditional FX option is an option contract in which a buyer can typically execute the terms of the contract prior to the expiration date if her or she feels that the market price of the underlying exchange rate has reached its peak (call options) or lowest point (put options). The payoff for the buyer depends on the difference between the strike price exchange rate, provided the market exchange rate moves in the buyer's favor. Assuming a favorable direction, the payoff amount correlates directly with the size of this difference.
What Are Binary FX Options?
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Binary FX options, also called all-or-nothing options, have only two possible outcomes: a fixed cash payoff specified in the contract's terms or no payoff at all. In a binary FX option contract, a buyer receives the payoff amount only if the market exchange rate exceeds (call options) or is less than (put options) the strike price exchange rate at the time the option contract expires. If the market exchange rate is not favorable at expiration, the buyer receives no payoff at all.
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