Currency Option

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Last Updated:December 18, 2023

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What Is a Currency Option?

A currency option is a contract that provides the right, not the obligation, to purchase or sell currencies at specified prices up to a specified expiration date. This benefits the investor by hedging against any opposing movements in exchange rates.

In this case, the buyer has to pay a premium to the seller. The premium paid to the seller is the maximum amount the seller would profit off from this deal, whereas the buyer would have unlimited profit potential if things were to go their way.

This premium price could be high or low, depending on the strike price and expiration date. Once you buy an option contract, generally, you are able to re-trade or sell it.

Investors implement a wide variety of strategies using currency calls and put options in the forex market. These strategies depend on the characteristics of each involved option (e.g. expiry date, strike price, long/short).

The options exchanges in the United States are regulated by several agencies, including the Securities and Exchange Commission and the Commodity Futures Trading Commission. Options can be purchased or sold through brokers for a commission.

There is also the over-the-counter market, where currency options are offered by commercial banks and brokerage firms. Unlike the currency options traded on an exchange, the over-the-counter market offers currency options that are tailored to the specific needs of the firm.

Key Takeaways

A currency option is a contract that provides the right, not the obligation, to purchase or sell a currency at a specified price up to a specified expiration date.
The main use of currency options is to hedge against any unfavorable movements in the exchange rates.
If the spot rate rises above the strike price, the owner of a call can profit by exercising the right to buy the currency at the strike price.
If the spot rate falls below the strike price, the owner of a put can profit by exercising the right to sell currency at the strike price.
To know when to exercise your call/put options, look at the difference between the spot rate (current exchange rate) and the strike price to know if you’re in the money, at the money, or out of the money.
Factors that affect a currency option’s premium include expiration date, volatility, and the difference between the spot rate and strike price.

What Are Call Options?

A currency call option grants the right to buy a specific currency at a designated price within a specific period of time. The exercise price, or strike price, is the price at which the owner is allowed to buy that currency. There are also monthly expiration dates for each option.

If the spot rate rises above the strike price, the owner of a call can exercise the right to buy the currency at the strike price.

Keep in mind that the spot rate is the current exchange rate, while the strike price is the exchange rate at which the contract can be ‘exercised’.

To exercise an option, the owner simply purchases the currency at the strike price, which will be cheaper than the prevailing spot rate. This is similar to a futures contract. The only difference is the buyer of the currency option is not obligated to exercise at maturity, whereas the other is.

A call option can be:

In the money → If the exchange rate > strike price
At the money → If the exchange rate = strike price
Out of the money → If the exchange rate < strike price

Factors that affect currency call option premiums

The premium is the amount the buyer pays to the seller. Hence, it’s the cost of having the right to buy the option. Three factors affect the amount of premium a buyer has to pay:

Spot price relative to the strike price: The higher the spot price relative to the strike price, the higher the option’s price will be.
Length of the time before expiration: The longer the time to expiration, the higher the option price will be. This is because there is more time for a spot rate to move above the strike price.
Potential variability of a currency: The greater the variability of the currency, the higher the probability that the spot rate can rise above the strike price.

Firms can use call options to:

Hedge future payables
Hedge project bidding to lock in the dollar cost of potential expenses
Hedge target bidding of a possible acquisition
Speculate on expectations of future movements in a currency.

Speculators may purchase call options in a currency they expect to appreciate or sell call options in a currency they expect to depreciate.

If they purchase call options:

Profit = Selling (spot) price - Premium price - Buying (strike) price

If they sell (write) call options:

Profit = Premium - Buying (spot) price + Selling (strike) price

What are Put Options?

A currency put option grants the right to sell a currency at a specified strike price or exercise price within a specified period of time. The owner of a put option is not obligated to exercise the option.

If the spot price falls below the strike price, the owner of a put can exercise the right to sell currency at the strike price. The maximum potential loss to the owner of the put option is the price (or premium) paid for the options contract.

The seller of a currency put option receives the premium paid by the buyer (owner). In return, the seller is obligated to accommodate the buyer in accordance with the terms of the currency put option.

A put option can be:

In the money → If the exchange rate < strike price
At the money → If the exchange rate = strike price
Out of the money → If the exchange rate > strike price

Factors that affect currency put option premiums

There are also three factors that influence currency put option premiums:

Spot price relative to strike price The lower the spot rate relative to the strike price, the more valuable an option is, and the higher the premium.
Length of time until expiration The longer the time to expiration, the greater the put option premium.
Variability of the currency: The greater the variability, the greater the probability that the option will make significant moves, possibly moving the option closer/further in the money. This makes the option more valuable.

Corporations use currency put options to cover any unfavorable movements against open positions in foreign currencies.

Currency put options that are deep out of the money come at a very low price. Deep out of the money means the current exchange rate is significantly higher than the exercise price.

If they are unlikely to become profitable and get exercised because their exercise price is too low, these options would then come at a lower price, meaning a lower premium.

Consequently, as the prevailing exchange rate declines lower than the exercise price, the price of these options would rise, meaning they are more expensive, as they are more likely to be profitable and get exercised.

Individuals may speculate in the currency options market based on their expectations

of the future movements in a particular currency.

Speculators can profit from selling currency put options as well. Contrary to the buyer, who has no obligations, the seller would be obligated to purchase the specified currency at the strike price from the owner who exercises the put option.

The speculator would profit from such options based on the exercise price, at which the currency can be sold versus the spot price of the currency and the premium paid for this particular put option.

Speculators may purchase put options on a currency they expect to depreciate or sell put options on a currency they expect to appreciate.

If they purchase, put options:

Profit = Selling (strike) price - Buying (spot) price - Option premium

If they sell put options:

Profit = Option premium + Selling (spot) price - Buying (strike) price

Examples of a Currency Option

Suppose the following:

An individual buys a British pound call option with a strike price of $1.50
The current spot rate at the date that he bought the call option is $1.48
The premium to pay for that British pound call option is $0.01$
Just before the expiration date, the spot rate of the British pound reaches $1.52
Since the spot rate, the current exchange rate, is higher than the strike price at which this individual bought the option, they should exercise the call option.
Once exercising, the individual can sell the pounds at the spot rate.

Assuming one option contract specifies 20,000 units, to calculate the individual’s profit:

Profit = Selling price (strike rate) - Purchase price (spot price) - Option premium

Profit = ($1.52 x 20,000) - ($1.50 x 20,000) - ($0.01 x 20,000)

Profit = $30,400 - $30,000 - $200

Profit = $200

The profit for the person on the other end of this deal, the seller of the call option, can be calculated using the following formula:

Profit = Selling (spot) price - Purchase (strike) price + Option premium

Profit = ($1.50 x 20,000) - ($1.52 x 20,000) + ($0.01 x 20,000)

Profit = $30,000 - $30,400 + $200

Profit = -200$

Currency Put Option example

Suppose the following:

An individual buys a British pound call option with a strike price of $1.30
The premium to pay for that British pound call option is $0.03
Just before the expiration date, the spot rate of the British pound reaches $1.25
Since the spot rate, the current exchange rate, is lower than the strike price, they should exercise the call option
Once exercising, the individual can sell the pounds at the spot rate.