A foreign exchange option — also known as a forex option, FX option or currency option — is a type of foreign exchange derivative that gives you the option to buy or sell currency at a specific price.
Options are intended to give you more flexible opportunities in the future and protect you from unfavorable fluctuations in the exchange rate of a currency.
How foreign exchange options work
Just like its name implies, a foreign exchange option gives you the choice to exercise a trade at a specified exchange rate, known as a strike price, up until an agreed-on date in the future, known as the expiration date or expiry date.
When you buy the right to an option, you pay a fee to the seller of that option, called a premium. If you acquire the right to buy a currency, you have a call option. If you acquire the right to sell a currency, you have a put option.
Foreign exchange options: An example
Let’s say you need to pay your overseas supplier 5.5 million yen (a little under $50,000) in 5 months. The dollar-to-yen exchange rate is great right now, but you don’t want to exchange your money and sit around with a bunch of yen for months.
What you can do is put a call option on the yen — one that gives you the right to buy the currency in 5 months at the current exchange rate. If the dollar weakens against the yen (in other words, if it buys you fewer yen), you can exercise your option. If the dollar strengthens against the yen, even better — you can simply lose the premium you paid for the option and buy yen at a superior price.
Why is a foreign exchange option useful?
You can use a foreign exchange option to protect yourself if exchange rates move against you.
Among the advantages of an option is its flexibility — it doesn’t force you to buy or sell currency. If exchange rates are unfavorable, you can choose not to exercise your option and simply lose the premium you paid to the seller of the option.
European vs. Canada and American options
European options can only be sold on the expiration date, while Canadian and American options can be bought/sold any time before that date.
For example, if you have a European call option on euros that matures on August 3, you’ll need to either buy euros or lose the option on August 3 — not before or after.
If you have a Canadian or American call option, you can buy euros any time before August 3.
What is a binary option?
Binary options are a much riskier type of option. They work as an all-or-nothing gamble that’s worth either $0 or $100 on the expiration date.
For example, let’s say you buy a binary option for $50 that says the euro/CAD dollar ratio will be more than $1.10/$1.00 on October 1, 2019 at midnight. When that date rolls around, if the ratio is higher than $1.10/$1.00, your option expires and is worth $100. But if the euro is worth less, your option expires and is worth $0.
How to trade forex options
If you want to trade foreign exchange options, you’ll need to find a reputable broker. While it is possible to trade options directly with a buyer or seller, known as OTC options, it’s generally much riskier than going through a reputable exchange.
Are there any drawbacks?
There’s always the possibility that you won’t be able to favorably exercise an option, in which case you’ll be holding a worthless option. If that happens, you won’t get back the premium you paid.
And if you purchased a binary option, you could lose all of the money you invested on the option.
Is there anything else I should know?
Typically, time is working against you when you buy an option. That’s because the less time you have left in an option, the less of a chance you’ll see a favorable window to exercise it.
Bottom line
Forex options are one way you can make money trading currencies. But no trades are risk-free trades, and you won’t get your premium back if you don’t use the option.
Money transfer services rarely offer foreign exchange options. However, you will find options at forex trading platforms and some banks.
Check the mid-market rate between the 2 currencies you’re trading. The mid-market rate is what your money’s actually worth on the global market compared to another currency. It’s the midpoint between worldwide supply and demand for that currency — and the rate banks and transfer services use when they trade among themselves.
Use the mid-market rate as a baseline to compare against the rates provided by your bank or transfer service.
Compare multiple money transfer providers. You may find a good rate at one provider but later find an even better rate elsewhere. We’ve compared the top money transfer providers to help you find the best rates.
Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading CFDs and forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades. Read the Product Disclosure Statement (PDS) and Target Market Determination (TMD) for the product on the provider's website.
Kevin Chen is a personal finance expert and a former writer at Finder. His expertise has been featured in CNN, U.S. News and World Report, Lifehacker and CreditCards.com, among other top media.
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