Options are available for trading in almost every type of investment that trades in a market. Most investors are familiar with stock or equity options, however options are available to the retail forex currency trader as well. Many people think of the stock market when they think of options. However, the foreign exchange market also offers the opportunity to trade these unique derivatives. Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates.
In finance, a foreign exchange option is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The foreign exchange options market is the deepest, largest and most liquid market for options of any kind. Most trading is over the counter (OTC) and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts.
One of the most common reasons for using FX options is for short-term hedges of spot FX or foreign stock market positions. For example, if you were buying EUR/USD but you thought there might be a short-term decline in the price, you could also buy a euro put option to profit from the decline while maintaining your buy. You could also sell EUR/USD short at the same time as buying. There are many bullish, bearish and even neutral strategies that can be implemented with options contracts. Spread strategies that are used in equity options can also be used with FX options, including vertical spreads, straddles, condors and butterflies.
The currency option market even has its own over the counter brokers that are distinct from the typical forex market brokers. The FX options market produces a large daily turnover making it one of the most liquid derivatives markets in the world. In forex options, the trading price is determined at the point of trade, but the physical exchange of the actual currencies is often fixed for a future date. Interestingly, most of the traders who trade forex options are speculators; hence, many of them close out their options contract before settlement and they rarely take physical delivery of the currency pairs.
A relatively recent trading choice that has expanded currency option availability to the retail market has been the advent of online forex option brokers. These brokers typically either make markets in traditional European and American style options like their counterparts in the OTC currency option market, or they offerexotic currency options like binary options to their clients looking to use them to speculate on currency pair movements.