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What
Are Forex Options?
Learning about forex options is crucial in
understanding how the foreign exchange market works. A
currency option is a contract that gives the holder the right
to buy
or sell the currency during a specific period of time, though
they are not obligated to do so. The specific price that the
currency is to be sold at is referred to as the strike price,
and the specific date that it should by sold by is called the
expiration date. The amount that the option buyer pays to the
option seller is called the premium.
There are two
basic types of options, they are call options
and put options. Simply defined a call option gives
the trader the right to buy, while the put option gives the
holder the
right to sell. It is important to note that on the foreign
exchange market for every put buyer there is a call seller.
At its expiration, the option is equal to the value realized
by the holder in exercising he option. If the holder of the
contract does not gain anything then the value of the option
is nothing. The value of the option during any other time other
than its expiration is called the intrinsic value.
The
intrinsic value of an option is the difference between
the strike price and the current or spot price. This is the
value of the option if it is exercised. The intrinsic value
of an option on the forex must be zero or above. An option
with no intrinsic value would be at zero, and would be considered
out of the money. Options with intrinsic value are said to
be in the money. These options have a spot price below the
strike price.
The extrinsic
value of an option is referred to as the time
value. It is defined as the value of a foreign exchange option
beyond its intrinsic value. The biggest factors in determining
extrinsic value are the volatility of the two spot currencies,
the strike price, the time left until expiration, and the interest
rate of both currencies. As the expiration date gets closer,
the extrinsic rate diminishes.
An option is priced according to a formula that takes into
account the spot value and extrinsic value. Options need to
be priced low enough to attract buyers, but also low enough
to attract option sellers, or writers.
The delta is the change in price of a foreign exchange option
compared to a change in the spot or current rate. The delta
falls between zero and one. The closer the delta is to one
the closer the strike price is to the spot rate.
Options are commonly used in the foreign exchange market to
minimize risks. This is because the investor that buys options
risk only what they paid for it. However, option sellers are
subjected to unlimited losses if the market moves unexpectedly.
For this reason options are commonly used as hedging
tools.
Companies that specialize in international trade will use forex
options to minimize their potential loss due to sporadic changes
in the market.
Foreign exchange trades have a unique option referred to as
the Digital Option. This special option will pay the holder
a specific amount of money at expiration if all the criteria
are met. If the criteria are not all met nothing will be paid.
The forex option market is increasing immensely. Currently,
it includes a growing number of individuals, brokers, companies
and banks. These members can participate via the telephone
or numerous online trading platforms. They can use options
to make profit or simply to minimize risks.
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