A currency option is a type of option that gives the holder the right, but not the obligation, to buy or sell a specified currency at a specified exchange rate on or before a specified date. Currency options are used by currency traders to hedge against exchange rate risk, or to speculate on changes in exchange rates.
What are the advantages of a currency options contract as a hedging tool compared with the forward contract? The main advantage of a currency options contract as a hedging tool is that it provides the holder with the ability to limit their downside risk. With a forward contract, the holder is exposed to the full extent of any adverse movements in the underlying currency, whereas with an options contract they can choose to let the option expire if the currency moves against them, limiting their losses to the premium paid for the option.
Another advantage of options is that they can be used to generate income through writing options. This is not possible with forwards.
What happens if you don't sell options before expiration?
If you don't sell your options before expiration, you have a few different outcomes that can occur, depending on what type of option you have purchased.
If you have purchased a call option, you are betting that the underlying asset will increase in value. If the asset increases in value, you can sell the option back for a profit. If the asset does not increase in value, the option will expire worthless and you will lose your initial investment.
If you have purchased a put option, you are betting that the underlying asset will decrease in value. If the asset decreases in value, you can sell the option back for a profit. If the asset does not decrease in value, the option will expire worthless and you will lose your initial investment.
If you hold an options contract until expiration and it expires worthless, you will have lost 100% of your initial investment.
How is currency option calculated? To calculate the currency option, one must first determine the underlying currency pair, the strike price, the expiration date, and the volatility.
The underlying currency pair is the currency pair that is being traded. The strike price is the price at which the option can be exercised. The expiration date is the date at which the option expires. The volatility is a measure of the underlying currency pair's price movements.
Once these factors have been determined, one can use a currency option calculator to calculate the currency option.
When should you exercise currency options?
The timing of when to exercise currency options depends on a number of factors, including the type of option, the underlying currency pair, and the market conditions at the time.
For example, if you are holding a call option on EUR/USD, you would want to exercise the option if the EUR/USD exchange rate rises above the strike price of the option. Conversely, if you are holding a put option on EUR/USD, you would want to exercise the option if the EUR/USD exchange rate falls below the strike price of the option.
Generally speaking, currency options are most often exercised at or near expiration, since this is when the greatest amount of time premium has eroded from the option's value. However, there may be times when it makes sense to exercise an option before expiration, such as if you are holding a deep in-the-money option or if there is a large move in the underlying currency pair.
What time currency options expire? In the United States, most currency options expire on the last Friday of the expiration month. If Friday is a holiday, the options will expire on the Thursday before the holiday.
The expiration time for currency options is typically at 10am New York time, but this may vary depending on the broker.