Tuesday, February 25th, 2020

Trading Foreign Currency Options


There are two reasons for trading foreign currency options. International businesses commonly make or receive payment in currencies foreign to their own. These companies trade foreign currencies and use Forex options trading in order to manage currency risk. Speculators look to take advantage of changes in currency value and may trade currencies directly or hedge risk and gain investment leverage by trading foreign currency options. Foreign currencies are traded one for another. It is, for example, the relative value of the dollar versus the Yen that matters. In trading foreign currency options a trader seeks to hedge risk or gain profit by analyzing the market and buying calls or puts on currency with another.

Trading Foreign Currency Options to Hedge Risk

A Japanese company wants to buy ten jets from Boeing. The new Dreamliner goes for about $200 million each. Payment will be in US dollars. The company has the money in hand and could simply pay up front. But they would rather have the use of two billion dollars in Yen until delivery when they must complete payment. But, if the Yen is rising in value versus the dollar it is smart to keep the Yen and change to dollars at the latest date possible. This would make the purchase cheaper in Yen. And, if the current Japanese economic strategy of devaluing the Yen works out it will make dollars more expensive and drive up the cost of the jets when paid for in Yen. Trading foreign currency options is common in such a situation. The Japanese company will buy calls on the US dollars with Yen. They will lock in the price that they need to pay to convert Yen to dollars and pay for their ten jets. If the dollar goes up in value versus the Yen they will execute the options contract and save money. If the dollar falls versus the Yen they will let the options contract expire and simply convert their Yen to dollars to pay for the jets and save money.

Currency Rate Speculation

The leverage of trading options makes this approach to currency trading very attractive. A trade looks for a low priced option contract on a Forex pair. His analysis of both fundamentals and the market tell him that buying calls on one currency with another will be profitable. He purchases the contract and pays a small premium. If he had purchased one currency with another he would have paid significantly more money. When the market moves he can exit the trade without ever owning either currency and pocket his profit. The rate of return on invested trading capital can be significantly better in trading foreign currency options than when buying and selling currencies. And the risk involved is always limited to the price of the options contract.

Homework Matters

Risk in trading foreign currency options is limited to the cost of an options premium in the case of buying calls. Risk is greater when selling calls or puts. The business of writing or selling options is typically limited to large trading houses with deep pockets. And no matter how you trade you need to do both fundamental and technical analysis of options in order to make the best trades. And you need to learn to always sit on your hands when you do not understand the market.

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