An option is a contract that gives the holder the right to buy or sell currency at a predetermined price at a predetermined price. The contract holder is entitled to exercise the option but has no obligation. Options are used as hedges in FOREX transactions; they are often used by overseas commodity trading companies to reduce risk.
Options have two different styles. Call options give contract holders the right to purchase currency. Put options give contract holders the right to sell money to others.
When the contract expires, the actual value of the option is the value obtained by the holder by actually exercising the contract. If the holder does not profit by exercising the option, the actual value of the option is zero. The value of the option at any other time during the contract period is the so-called intrinsic value, ie the value of the holder's then exercised option.
Intrinsic value is based partly on the pricing of the contract, also known as the "execution price." If the current currency price is higher than the strike price, the call option has intrinsic value. This will allow the contract holder to buy currency at a price lower than the current value and then sell it for profit. If the current price is lower than the strike price of the option, the put option has intrinsic value.
At any time, when an option has a positive intrinsic value, if the intrinsic value is negative, then it is considered to be "in the currency", then the option is considered to be "exceeding the currency". It can also have a value of zero, which means that the current price is the same as the execution price, in which case it is considered to be "a sum of money." Options can only be exercised when they are "rich."
There are some complex formulae used to calculate the intrinsic value of options. These formulas consider both the current price and the time value. The time value is calculated based on the market conditions, including the interest rates of the two currencies and the remaining time of the contract. The pricing of options is subtle; they must be low enough to attract buyers but high enough to attract sellers.
Options are mainly used to minimize the risk in foreign exchange transactions. They help prevent accidental fluctuations in the market. When you purchase an option, your potential loss is limited to the price of the option. When you sell options, your potential loss may be higher. The seller receives a premium on the put option, but depending on the market trend, their losses may be unlimited.
As a hedging tool, there are many different types of options available. They are usually used to minimize the losses of overseas trading companies caused by fluctuations in the foreign exchange market.
In the foreign exchange market, there is a special option called the digital option. If certain criteria are met, the digital option will pay the specified amount when it expires. If it does not meet the standard, no payment will be made.
For our digital options, traders must first determine the direction of the market. If the market moves as expected within a specific time frame, they then determine a return amount. Then using this information, they can calculate the price of the digital option.
For example:
The current price of the euro is approximately 1.2400, and you are expected to rise to 1.2800 within 3 months. You decide to buy a number option with a $5,000 return. The cost of this option is $800.
If the euro exceeds 1.2800 at the end of 3 months, you will receive $5,000. If the price is less, you will lose 800 dollars.
Options can be a valuable trading tool for all Forex traders.
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Orignal From: Forex - Use Options to Reduce Risk
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