The term forex options refer to a contract in which buyer has the right but not an obligation of selling or purchasing any particular forex spot for defined strike price before the expiry date. In such contract forex options premium means the payment buyer makes to seller for contract rights.
Initially, forex options trading developed as an OTC medium for banks and financial institutions with the aim of forex hedging their exposure to foreign currencies. Another thing about forex options is that it is known as inter-bank market similar to the spot market but with time forex options trading has become common with large corporations as well as individual investors who want to hedge their exposure to other currencies. The advantage of forex options trading is that it provides flexibility in deciding forex hedging and trading strategies to investors.
A Forex Options Transaction
In forex options transactions buyer can decide whether to sell the contract before it expires or hold it till expiration and then take position in the specified spot forex. The decision to take position in the spot market is commonly known as assignment. The primary obligation of the buyer is to pay the premium amount upfront to the seller at the time forex option is purchased.
Expiration of Forex Options
Forex options will expire worthless in case strike price is what is known as out or money. Simply it means that spot price is less compared to strike price of call option. If the forex option becomes worthless then both parties; seller and buyer will not have any obligation towards the other.
Extrinsic and Intrinsic Values
Intrinsic Value: Any forex optionÓ³ intrinsic value is calculated to be the difference in contract rate and strike price. This value stands for forex options actual value in case it is exercised. In case any forex option does not have intrinsic value then it will be deemed to be out of money. On the other hand, if forex optionÓ³ strike price is close to the spot rate then it will be called at the money.
Extrinsic Value: It generally refers to the time value of forex options and is a number beyond intrinsic value of any forex option. The extrinsic value is calculated based on many different factors such as spot currency volatility, time till expiration, riskless rate of interest for the 2 currencies, present spot price for 2 currencies, and lastly the strike price. In addition to it you should also know what as expiration date closes, the extrinsic value starts to wear down for any particular forex option. A small example will clearly illustrate what is meant here, suppose a forex option has sixty days to expiration, then such forex option will be more valuable than any forex option which will expire in another thirty days.
A Final Note
To conclude we can say that forex trading options are quite useful and proper utilization of forex options can be beneficial for investors. Additionally, having proper information about the roles of buyers and sellers in forex option contracts will guide you in making the right decision at the right time.