What is a currency option?
A currency option is one of the types of issued securities. Such a document is especially popular in the foreign exchange market and in banking. It is mainly acquired by traders who earn from buying and selling foreign currency.
How does a currency option differ from ordinary ones?
An option is a contract in which one of the parties acquires the right to sell or buy an underlying asset at a fixed price within a pre-agreed period of time. A document is called a currency option when the underlying asset is a currency unit. Such securities are very common in interbank relations and on specialized markets.
Each contract must specify the following points:
1) Type of document. A security can be divided into two types depending on the right it grants after purchase.
2) Underlying asset. The currency pair that is the main object of the contract must be precisely specified.
3) Strike price (exercise price). The option seller is obliged to sell or buy the asset at this price regardless of how it changes over time.
4) Expiration period. The buyer may exercise their right only within a certain period, usually from several days to several months.
5) Option premium — the amount of money that the buyer pays to the seller at the moment the contract is concluded. This payment is a kind of compensation for the risk assumed by the seller and is often called the option price.
Main types of currency options
The contract holder may either sell or buy the underlying asset. Depending on this, contracts are divided into two types.
Call options
A call option (buyer’s option) is a contract in which one party receives the right to buy the underlying asset. The selling price is agreed in advance and does not change throughout the entire term of the transaction. The seller is obliged to sell the asset at the strike price regardless of how much it differs from the market price, and in return requests a small premium.
A currency option is an excellent way to earn from exchange rate fluctuations. A trader purchases it in the hope of an increase in the value of the base currency in the near future. Unlike direct currency investments, buying such a security involves minimal risks, because even if the underlying asset depreciates significantly, the trader will lose only the money paid to the seller as a premium.
Example of using a currency call option
A trader purchases a security for buying euros at the current exchange rate (for example, 50 rubles). He does this in the hope that during the validity of this right the exchange rate will start to rise. The premium is 5% of the amount that can be purchased. If the investor wants to obtain 1,000 euros, he must pay 50 euros to the seller. A currency call is profitable only if the rate increase exceeds 5%; otherwise, the buyer will give the seller more than he earns from the difference between the strike and market prices.
Suppose that during the specified period the euro rises by 10%, which means the investor will receive a 5% profit on the invested amount, that is, 10% growth minus the 5% premium. If 5% is calculated from 1,000 euros, the profit will be a modest 50 euros. Experienced investors work with much larger sums, and even such a small increase can yield an excellent income.
Put options
A security that gives the holder the right to sell an asset at an agreed price is called a put option.
In the currency market, puts are mainly needed to insure existing currency investments. For example, if a trader holds savings in foreign currency but soon learns about upcoming inflation, he purchases a put option and can remain calm: the invested funds will be returned to him minus a minimal expense for the contract.
Example of using a currency put option
One can earn not only from the growth of currency exchange rates, but also from their decline. To do this, it is necessary to sell the currency in the future at the price that is valid at the present moment. This is why many investors use currency put options.
Suppose currency market data indicate an imminent fall in the dollar exchange rate. Such information is a good opportunity to make money, but certain difficulties arise, because in the usual sense currency inflation means losses of savings. In reality, with the right approach, even negative changes in exchange rates can generate profit.
An investor acquires an issued security for selling a certain amount of dollars at the current price and pays 5% of the amount he wants to sell for this right. During the contract period, the dollar falls by 20%. The trader buys 20,000 dollars at the current price and sells them to the option issuer at the strike price. Taking into account the premium, which always remains with the seller, the trader earns 15% profit from the transaction, that is, 3,000 dollars.
“Geographical” types of currency options
Securities of this kind first appeared in Europe but gained great popularity in America. Gradually, the procedure for exercising the right secured by an option began to change depending on geopolitical affiliation: American options operate according to one principle, European ones according to another. In Asia, the American type of security found yet another variation.
American option
At present, the American model is the most popular and widespread. It is used everywhere and, oddly enough, even in Europe.
Its main difference from the European model is that the buyer has access to early expiration — the exercise of the rights granted by the option.
Early execution of the contract is beneficial for its holder. During its validity, the asset price may rise sharply or, on the contrary, fall. The trader has the right to convert currency at the moment that is most advantageous to him.
European option
Premiums on such documents are slightly below the average level. This is because the seller faces minimal risk, since the buyer cannot use early expiration. A certain period must pass from the moment the contract is concluded until its execution. Only after this time can the buyer exercise the right. He cannot profit from intermediate increases or decreases in the asset price.
Asian option
An option is, in a sense, a commodity, and it must have its own price. From the very moment global options exchanges appeared, many analysts asked the question of how to correctly calculate the premium.
The fairest pricing model turned out to be one based on the average price of the asset over a certain period. It was first tested by a branch of an American bank in Tokyo. Soon, contracts whose premiums were calculated in this way began to be called Asian options.
Exotic types of currency options
Gradually, the concept of what a currency option is began to change and take on a completely different form. Types of such documents appeared that have only a distant relation to ordinary securities.
Barrier currency options
Options are a form of gambling. Each party to the agreement strives to obtain maximum profit and is ready, in the event of an unfavorable outcome, to lose everything.
Barrier currency options became the first step toward transforming an ordinary security into a global digital market, where the main idea of each participant is to obtain as much money as possible.
Barrier contracts differ from ordinary ones by the presence of an obstacle on the path of exercising the right to buy or sell an asset: for the document to be converted, the price of the underlying asset must reach a certain level.
Since the buyer’s risk increases, the contract specifies a more favorable price for him, which may differ significantly from the market price. For example, the seller undertakes to sell dollars at a price of 35 rubles (while they currently cost 40) provided that within one month their price reaches 45 rubles.
With the rise in popularity of barrier transactions, the underlying asset gradually began to leave circulation. Instead of buying and selling currency, the seller of the security simply compensated the profit that the buyer could have obtained from further transactions. This approach is beneficial for both parties: the seller spends less time, and the buyer is insured against additional risks, for example, that the exchange rate may change unfavorably between conversion of the document and resale of the asset.
Range currency options
In this case, the buyer can exercise his right only if the currency exchange rate at the moment of contract execution is within a certain range: greater (less) than number N, but not greater (less) than number N+M.
For example, a document to buy dollars at a price of 35 rubles can be exercised only if at expiration the exchange rate is in the range of 36–40 rubles. The price range is proposed by the seller, and the buyer has the right to demand its modification.
The range may be at the level of the current rate, higher than it, or even lower. Essentially, the investor is betting on an increase or decrease in the value of the asset.
Binary currency options
The final stage in the transformation of ordinary securities was binary options. They differ very strongly from their predecessors, and it is possible to trace any similarity only by understanding what barrier and range contracts are.
In binary options, the asset has completely left circulation. The main object has become its price. Traders place bets on its behavior over a certain period of time. If they believe it will rise, they place a “call”; if it will fall, a “put.” As you can see, even the concepts of call and put have lost their former meaning.
The exercise price does not depend on the behavior of the asset in the currency market: it is set by the broker (option seller). The exercise price is expressed as a percentage of the bet amount. The option premium depends on the buyer: the more he stakes, the more he can earn and the more he can lose. The premium remains with the broker only if the investor’s bet does not pay off. Thus, regardless of the outcome, only one party to the agreement ends up with the money, which is why such transactions are often called “all or nothing.”
Currency options in banking relations
At present, the most accessible sellers of options are second-tier banks. They distribute securities among both individuals and legal entities.
Ordinary citizens can acquire this security as a guarantee of reimbursement of a deposit in foreign currency. Options for individuals are a new direction in banking investment, so it is worth discussing it in more detail.
A currency option with deposit coverage is an opportunity to obtain a more favorable deposit interest rate and at the same time a fairly serious financial risk. Essentially, this is a put option: the client opens a deposit in the base currency and acquires the right to sell this currency to the bank. The document specifies the exchange rate chosen by the client, as well as the size of the bank’s premium. The range of the possible exchange rate is chosen by the bank. The contract term ranges from one week to one month. If upon expiration the rate chosen by the client is more favorable than the current one, he may exercise his issued document and convert his savings into currency at a more favorable rate. In addition, the bank refunds the premium amount.
If the chosen rate is lower than the current one, the client leaves the right unexercised, and the premium remains with the bank.
For example, a client opens a deposit of 100,000 rubles and purchases from the bank an option to convert this amount into dollars at a rate of 38 rubles. At the moment, the rate is 40 rubles. The expiration period is one week. For the contract, the client must pay 10% of the deposit, but only if he does not exercise it.
If at expiration the dollar rate remains unchanged or even increases, the client benefits. He exercises his right and converts the deposit into dollars at a rate below the market one. The bank reimburses the cost of the security as a bonus. If the dollar rate falls below 38 rubles, it will be unprofitable for the client to exercise the option. He simply lets it expire and loses 10,000 rubles (the option premium).
Despite how appealing it may sound, such a banking offer is not very profitable. The bank sets strict conditions that do not allow the client to obtain significant profit. Deposit interest rates are usually below the market average, and a favorable change in the exchange rate only compensates for this difference.