Hedging your bets against the future: the forex option

All speculation-based markets are full of uncertainty, and none more so than the

forex market. A currency might be strong and vibrant today, weak and sickly a

month from now. One way to guard against major fluctuations like that is through

forex option trading.

A forex option is when you buy the right -- but not the obligation -- to buy or sell a

particular currency at a particular rate any time between now and the expiration

date of the option.

Let’s say you’re worried that the Japanese yen is going to drop in value

sometime in the next six months. You might buy an option that basically locks in

the current exchange rate for whatever period of time the option seller allows,

usually anywhere from 30 days to six months. You set a number of yen, too. Say

you choose 10,000 yen at a rate of 116 yen per U.S. dollar for three months. The

option basically says, “I may want to sell 10,000 yen sometime in the next three

months, but I’m worried the yen is going to devalue in that time. So I’ve locked in

this rate of USD/JPY 116.”

Then three months pass. If your prediction was correct and the yen has

weakened in that time -- say it’s now USD/JPY 122 -- then you exercise your

right to sell 10,000 yen at the rate you bought three months earlier. Everyone

else selling yen today (everyone who didn’t have a forex option, that is) is selling

it at 122 per U.S. dollar, and you get to sell it at 116.

If, on the other hand, the yen has stayed the same or gotten stronger, you are

under no obligation to actually sell that 10,000 yen your option talked about. You

can simply do nothing, and all you’ve lost is the premium you originally paid for

the option.

Ah yes, there is a premium. Brokers who sell forex options charge a fee for the

privilege. Think of it as insurance; calling it a “premium” certainly fits. The price of

a forex option for 10,000 yen for three months might be $200, which you must

pay up front. If the yen drops enough in value, you’ll hopefully turn enough of a

profit to make up for the $200 you had to pay. If it increases in value, and you

wind up not exercising the option, all you’ve lost is the $200 premium.

Forex option trading used to be done only by major banks and corporations, but

now many brokers who cater to individual traders offer the service, too. If you’re

a heavy-duty trader, a forex option is definitely something to consider to guard

against future setbacks in the currency you hold.

 

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