A currency option is a contract between a buyer and a seller
that gives the buyer the right, but not the obligation, to trade a specific
amount of currency at a predetermined price and within a predetermined period
of time, regardless of the market price of the currency; and gives the seller,
or writer, the obligation to deliver the currency under the predetermined
terms, ifand when the buyer wants to exercise the option. More factors affect
the option price relative to the prices of other foreign currency instruments.
Unlike spot or forwards, both high and low volatility may generate a profit in
the options market. For some, options are a cheaper vehicle for currency
trading. For others, options mean added security and exact stop-loss order
execution.
Currency options constitute the fastest-growing segment of
the foreign exchange market. As of April 1998, options represented 5 percent of
the foreign exchange market. The biggest options trading center is the United
States, followed by the United Kingdom and Japan. Options prices are based on,
or derived from, the cash instruments. Often, however, traders have
misconceptions regarding both the difficulty and simplicity of using options.
There are also misconceptions regarding the capabilities of options. Trading an
option on currency futures will entitle the buyer to the right, but not the
obligation, to take physical possession of the currency future. Unlike the
currency futures, buying currency options does not require an initiation argin.
The option premium, or price, paid by the buyer to the
seller, or writer, reflects the buyer's total
risk. However, upon taking physical possession of the
currency future by exercising the option, a
trader will have to deposit a margin. The currency price is
the central building block, as all the other factors are compared and analyzed
against it.
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