What are Foreign Exchange (FX) Options?
Foreign exchange options are derivatives of equity index futures. They are used in an attempt to hedge a portfolio against fluctuations in the US stock market, which may be advantageous if the investor is not comfortable with a high degree of leverage. According to Fintalent’s Foreign Exchange (FX) Options consultants, Foreign exchange options allow an investor to trade based on his or her expectations for movements in USD/JPY, EUR/CHF, and GBP/AUD pairs.
Foreign exchange options allow an investor to trade based on his or her expectations for movements in USD/JPY, EUR/CHF and GBP/AUD pairs. For example, one option contract has a 20-day expiration date and may be traded at any 60-day interval: 80 days, 120 days or 180 days. There are five expiration dates that can be used with options contracts: one month, three months, six months, one year and two years.
Foreign exchange options are often bought in conjunction with an option pool. An option pool is a portfolio of options that has been selected for the purpose of hedging against market risk. For example, a hedger may decide to write a maximum of five monthly calls against his/her currency-hedged portfolio and then buy back three to four puts. The investor will not want to be at risk for seven consecutive months without having the benefit of any offset for these contracts.
These contracts, like all other derivatives, do not necessarily have a predetermined expiration date. Additionally they can be written out as many times as needed without having to pay an additional premium in order to replicate the original underlying product. Different types of foreign exchange options exist, depending on the currency pair or asset being hedged against and the number of options composing the underlying product:
• Currency Options: are traded for periods between 10 and 60 days with a fixed premium over the spot price at the start of trading. They can be traded either for delivery or for settlement. Currency options can be cash settled, or physical delivery can be requested on the expiration date.
• Currency Pairs: are similar to currency options with the exception of an underlying value designed to protect against movements in any given market. These pairs are built from two currencies and are traded over a period between 10 and 60 days with a fixed premium over the spot price at the start of trading. Traders may buy or sell these contracts out as many times as needed without having to pay an additional premium in order to replicate the original underlying product. These contracts can be cash settled, or physical delivery can be requested on the expiration date.
• Spreads: are often used to protect against a rise in the value of a currency. For example, if an investor wants to hedge his/her exposure to the change in USD/JPY he/she can buy a spread for USD/JPY which involves selling one USD/JPY call and simultaneously buying three USD/JPY puts (for a net debit of $300,000). This way the investor is protected against the possibility of USD/JPY rising above 105.50 within a time period between 90 and 100 days.
• Straddles: are options that use two different dates for expiration and allow traders to profit from significant market moves in either direction within a moderate amount of time. For example, if an investor wants to hedge his/her risk of USD/JPY increasing or falling by more than 10% within a one-month period he/she can buy a straddle for $1.30 and sell 1.85 puts ($550,000 in net credit). The trader is protected against the possibility of USD/JPY rising above 106.50 within a time period between 90 and 100 days.
• Strangles: are options that use two different dates for expiration and allow traders to profit from significant market moves in either direction within a very short amount of time. For example, if an investor wants to hedge his/her risk of USD/JPY increasing or falling by more than 10% within a three-day period he/she can buy a strangle for $1.30 and sell 1.85 puts ($550,000 in net credit). The trader is protected against the possibility of USD/JPY rising above 106.50 within a time period between 0 and 3 days.
• Parabolic Straddles: are options that use two different dates for expiration and allow traders to profit from significant moves in either direction within a moderate amount of time. For example, if an investor wants to hedge his/her risk of USD/JPY increasing or falling by more than 10% within a 2-week period he/she can buy a parabolic straddle for $1.30 and sell 1.85 puts ($550,000 in net credit). The trader is protected against the possibility of USD/JPY rising above 106.50 within a time period between 14 and 20 days.
