FX Options
Foreign exchange options, or FX options, are derivative financial tools that deal in currencies. The world currency market is the largest market in the world, and the most the liquid. Investors trade FX options as part of this market. In addition to trading and speculation, FX options serve important business functions as well.
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Features
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A foreign exchange option is a contract that gives the holder the right, but not the obligation, to purchase a currency at a preset exchange rate. Some FX options only allow the holder to exercise the option on a specific date. Others allow the holder to trade at the contract rate up to and including the specified date. The issuer of the FX option charges the holder a premium, regardless of whether or not the holder exercises the option.
Benefits
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Foreign exchange options allow businesses to operate better by removing uncertainty. They also help businesses to hedge against foreign exchange risk. Other financial derivatives also have these benefits -- what is unique to the FX option, is the limited risk factor. If at the contract date it is more beneficial to trade on the spot market, rather than at the option rate, the holder simply does not exercise the option and the only loss is the premium.
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Trading in FX Options
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Usually, businesses looking to hedge against foreign exchange risk or individual speculators purchase foreign exchange options, issued either from banks or from FX clearinghouses. In either case, trade takes place on the open market. Speculators want to purchase options that will give a discounted exchange rate versus the spot market rate. When this happens, a speculator can exercise the option at the cheaper rate, and immediately turn around and sell in the spot market to earn a profit.
Risk
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Unlike other financial derivatives, foreign exchange options carry comparatively low risk. If an investor buys a future contract and, on the contract date, market conditions have become unfavorable, the investor has no choice but to honor the contract and take a potentially huge loss. If an investor encounters the same scenario with an FX option, the investor simply chooses not exercise the option. His only loss is the flat rate premium he paid upfront to acquire the option.
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