A foreign exchange option — also known as an FX option or currency option — is a type of foreign exchange derivative. It’s all about giving you more flexible opportunities in the future and protecting you from unfavorable fluctuations in the exchange rate.
What is a foreign exchange option?
Just like its name implies, a foreign exchange option gives you the option to buy or sell an amount of money in one currency for another currency. You can exercise this option at a specified exchange rate up until an agreed-on date in the future.
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.
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.
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.
Compare providers that can help you set up foreign exchange options
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.
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.
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