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 five 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 five months at the current exchange rate. If the dollar weakens against the yen (it 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. American options
European options can only be sold on the expiration date, while 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 an 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/US 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.
Compare forex trading platforms
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.
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 two 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.
Kevin Joey Chen is a credit cards, banking and investments writer whose work and analysis have appeared on CNN, U.S. News & World Report, Business.com, Lifehacker and CreditCards.com. He's passionate about helping you get your finances in order by expertly navigating cutting-edge financial tools — including credit cards, apps and budgeting software.
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