FX Options
FX Options are short for Foreign Exchange Options (also called Currency Options), and have many similarities to stock options. With stock options, the owner of the option contract has the right (but not the obligation) to purchase a certain amount of shares of the underlying stock at a particular price (called the strike price). FX options give the owner the right (but not the obligation) to exchange money denominated in one currency into another currency at a pre-agreed exchange rate (the strike price) on a specified date.
You will notice that both stock and FX options have a purchase and sale price (bid and ask), both revolve around a strike price (the rate of exchange) and both can be exercised for an underlying security (an individual stock or currency).
FX Options currently trade on two major listed US exchanges and are branded as products of those exchanges. The International Securities Exchange offers ISE FX Options and The NASDAQ Stock Exchange offers World Currency Options.
The ISE FX options are bought and sold on the investor’s view of the U.S. Dollar relative to other securities. For example, if you believe the U.S Dollar will be stronger than the Euro, you would buy call options on the U.S./Euro ISE currency pair. If you feel the U.S Dollar will be weaker against the British Pound (GBP), you would buy put options on the U.S./GBP ISE currency pair. As of September 2009, ISE offers additional FX options quoted conventionally as opposed to only dollar based.
Why trade FX Options?
FX Options are an alternative investment in your portfolio, and serve several purposes in your overall investment strategy.
- Turning a potential profit on the strength/weakness of the US dollar can be done using a longer term investment horizon.
- Use FX options to trade on predictions of market movements before fundamental events take place (such as economic reports or meetings) with a predefined risk profile.
- Your downside risk is limited to the option premium (the amount you paid to purchase the option).
- You have unlimited profit potential.
- You get to set the price and expiration date.
- You can protect against open spot (cash) positions and limit risk.