Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-28T15:42:46+05:30
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Currency options are a popular financial instrument that can help individuals and companies manage their foreign exchange risks. With the volatility of global currencies, it can be challenging to predict how exchange rates will move in the future. However, currency options offer a flexible and effective way to mitigate the risks associated with these fluctuations. By understanding the mechanics of currency options, investors can take advantage of market opportunities while minimizing potential losses. 

In this article, we will dive into currency option trading, exploring the currency options definition, benefits, terminology, and key elements.
 

What is Currency Options?

Currency options are a powerful kind of investment vehicle that provides the holder with the right, but not the responsibility, to purchase or sell a certain currency at a predefined rate of exchange on or before a specified date. The holder is required to make a premium payment to the seller in order to maintain this privilege.

Currency options are widely used by businesses, individuals, and financial institutions as a means of managing risk and protecting themselves against fluctuations in exchange rates. By locking in a specific exchange rate through a currency option, the holder can hedge against adverse movements in the currency market.
 

Types of Currency Options

Currency options come in two primary types. Both types of currency options allow the purchaser to sell or buy a specific currency pair at a pre-determined exchange rate before the contract's expiration date. Let's explore each type of currency option trading:

1.    Currency Call

A contract that permits the buyer to buy a particular currency pair at a pre-established strike price on or prior to the contract's expiration date is referred to as a currency call option. This type of option is typically used when the buyer expects the price of the currency pair to rise. In case the currency pair falls below the strike price upon option expiration, the option will become worthless, and the seller will retain the premium.

2.    Currency Put

A currency put option is an agreement that enables the purchaser to vend a specified currency pair at a prearranged strike price at any time before the contract's expiry. This type of option is typically used when the buyer expects the price of the currency pair to fall. In the event that the currency pair is higher than the strike price at expiration, the option becomes useless, and the premium is retained by the option seller.

Regardless of which type of currency option is chosen, the buyer is essentially paying a premium for the right to buy or sell a specific currency pair at a predetermined price before a specified date. This allows traders and investors to hedge against fluctuations in currency markets and manage their risk exposure.
 

How to Trade Currency Options?

In India, the National Stock Exchange (NSE) provides trading services for currency futures on four currency pairs and options on three currency pairings, including options on the Indian rupee against major currencies, including the euro, pound, and the US dollar.

Trading currency options are relatively simple. Call or put options can be purchased through a stockbroker or online trading platform. These options are European-style, meaning they can only be used until they expire, but you can resell the options contract on the market to complete the deal. The net profit or loss can be expressed as the disparity between the amounts paid for purchasing and vending the premiums.

To initiate trading, you must remit a premium to your broker, who will subsequently transfer it to the exchange, which will, in turn, remit it to the option seller or writer. With relatively cheap premiums, you can use leverage to trade in large volumes.

However, it's crucial to keep in mind that currency markets can be volatile, and timing is crucial. As such, it's important to conduct thorough research and seek professional advice before investing.
 

Currency Options Terminology and Elements

Currency options trading involves a specific set of terminology and elements that traders must understand to participate in the market effectively. Apart from knowing the currency options meaning, here are some of the key terms and elements you should know:

1.    Spot Rate

The spot rate refers to the present exchange rate, which fluctuates continually due to market changes.

2.    Strike Price

The strike price is the currency exchange rate at which the option agreement can be executed. The buyer can either buy or sell the currency at this rate.

3.    Call Option and Put Option

A call option confers upon the purchaser the entitlement to purchase a currency at the strike price, whereas a put option entitles the buyer to vend a currency at the strike price. It's important to note that buying a call option on one currency is the same as buying a put option on the other currency in the pair.

4.    Expiration Date

The expiration date is the date on which the option contract expires, and the buyer can no longer exercise their rights.

5.    Contract Size

The contract size determines the amount of currency being settled in the transaction.

6.    American vs. European

American options are executable at any moment, either before or on the expiry date. In contrast, European options can only be executed on the expiration date.

7.    In-the-Money and Out-of-the-Money

An option is considered in the money when the option can be exercised and it's profitable for the buyer to do so. On the other hand, an option is considered out-of-the-money when exercising it would result in a loss for the buyer.

8.    Premium

The sum disbursed by the purchaser to the vendor for the option agreement is recognized as the premium. This amount is determined by supply and demand, as well as the strike price's position in or out of the money.
 

Benefits of Currency Options

Currency options can provide a range of benefits to traders and investors who want to speculate or manage currency risk. Here are some of the advantages of trading currency options:

●    Currency options provide traders with leverage in their trades since the premium expense of the option contract is comparatively low in comparison to the actual cost of purchasing the underlying asset. Consequently, traders can take substantial positions for a small premium, leading to significant profits in the event of a favorable market movement. Nonetheless, it's essential to note that leverage can also amplify losses if the market moves in the opposite direction, making effective risk management critical.
●    Currency options can also be used as a low-cost hedging strategy to protect against unfavorable currency movements. For example, a company that has foreign currency exposure can use currency options to hedge its currency risk by buying put options to protect against a potential decline in the value of the currency. This can help to minimize losses and stabilize cash flows, especially in volatile markets.
 

Understanding Currency Options

Understanding currency options is essential for traders and corporations that want to hedge against currency risk and potentially make profits.

The profit and loss diagram presented above depicts the outcome based on the spot rate at the option's expiration or time of exercise. To illustrate, suppose the buyer intends to sell CAD and buy USD but predicts that the CAD will depreciate relative to the USD in the future. To hedge against this depreciation, the buyer acquires a call option on the USD.

The call option's strike price is 1.2 USD/CAD, which entitles the purchaser to vend CAD at 1.2 USD/CAD before the contract's expiration. If the CAD devalues further to the right of 1.2 USD/CAD, the buyer will execute the option as it will be profitable. At the strike price, the buyer will be indifferent to exercising or not, ignoring any potential exercising fees. On the other hand, if the CAD strengthens against the USD to the point left of the strike, the option becomes out-of-the-money and therefore has no value, leading the buyer to suffer a loss equal to the entire premium paid for the option.

The total premium is computed by multiplying the premium by the contract size. In this case, the contract size is 50,000 USD, and the premium is 0.1 CAD, resulting in a total premium of 5,000 CAD. This figure also denotes the highest possible loss on the agreement.

The breakeven spot rate is determined by adding the strike price and the premium. For this example, the breakeven rate is 1.2 + 0.1 = 1.3 USD/CAD. The breakeven rate can be thought of as the spot rate needed to recoup the total premium paid.

If, at the contract's expiry, the spot rate surpasses the breakeven rate, the buyer will exercise the call option and vend CAD at 1.2 USD/CAD, whereas the market value is 1.3 USD/CAD. The gain will be determined by multiplying the contract size by the discrepancy between the strike price and the spot rate. In this case, the buyer will earn (1.3 - 1.2) * 50,000 = 5,000 CAD. This profit is the exact amount to offset the total premium incurred for the contract.

Any spot rate falling between the strike and breakeven will lead to a net loss since the profits will not be adequate to counterbalance the entire premium paid. Consequently, for the purchaser to derive a benefit from the agreement, they must foresee the CAD declining below the breakeven level of 1.3 USD/CAD.

It's important to note that option contracts are a zero-sum game. The buyer's profits from exercising their in-the-money option come at the expense of the seller's losses. If the buyer prefers not to exercise their out-the-money option, the seller will earn a profit from the premium paid by the buyer. Although the buyer has the option to exercise or not, the seller has no choice but to honor the buyer's decision.
 

Conclusion

Currency options are a valuable tool for investors and businesses alike to manage their currency risk exposure. They provide flexibility in terms of hedging and can also be used for speculation or leverage. Understanding what is currency options and how they work is essential to making informed investment decisions. By carefully analyzing market conditions and employing effective strategies, investors and businesses can use currency options to achieve their financial objectives and mitigate currency risk.

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Frequently Asked Questions

One of the best ways to trade currency options is by buying a call option on a currency pair that you believe will appreciate against another currency. For example, if you think the US dollar will strengthen against the Indian rupee, you could buy a call option on the USD/INR pair. Similarly, you could buy a put option on a currency pair if you anticipate that it will depreciate.

Trading currency options involve significant risks due to fluctuations in currency prices. There is always the risk that the market will move against you, resulting in a loss. Additionally, risk management systems can provide limited protection, but they do not completely eliminate the risk of losses. 

One way to protect against currency fluctuations is by using currency option hedges. For example, if you are a business owner who regularly engages in international trade, you could use currency options to protect against adverse exchange rate movements. By purchasing a put option on a currency pair, you can limit your losses if the currency depreciates while still participating in potential gains if the currency appreciates.

The price of a currency option is affected by various factors, such as the underlying security's price, the option's moneyness, its useful life, and implied volatility. For instance, the closer the option's expiration date, the less time there is for the underlying currency pair to move in the option holder's favor, which lowers the option's price. Moreover, implied volatility, which is the market's expectation of how volatile the underlying currency pair will be, can significantly impact the option's price.

Currency options diverge from other options in that they grant the holder the entitlement, rather than the responsibility, to convert one currency to another at a later time. The agreement outlines the currencies and the quantities engaged in the conversion. In contrast, other options, like stock options, provide the owner the right to sell or purchase a specific stock at a predetermined price without the ability to exchange it for an alternative asset.