When it comes to financing, foreign exchange option which is commonly shortened to FX option or currency option, happens to be a derivative financial instrument which gives us the right but not the obligation, to exchange any money which is denominated in one currency, into another currency at an agreed-upon exchange rate on a specific day.
The forex options market happens to be one of the deepest, largest and also the most liquid market in the entire planet. Most of the trading happens over the counter and is very lightly regulated, but a huge fraction is traded in exchanges like the international securities exchange, Chicago exchange, futures contracts and more. The global market for the exchange currency options was actually valued by the bank of international settlements at a whopping $159 trillion in the year 2005. Imagine how much it would have grown in 15 years, till 2020. I am sure that the number is much higher by now.
It wouldn’t hurt to know some terms now, would it?
Call option: It is the right to purchase an asset at a fixed price and a specified date.
Put option: It gives you the right to sell an asset at a fixed price and a fixed date.
Foreign exchange option: Gives you the right to sell money in one particular currency and purchase money in another currency at a fixed rate and a fixed date.
Spot price: It is the price of an asset at the time at which the tree takes place.
Forward price: It is the price of an asset for the delivery of it, at a future date.
Let me go ahead and give you an example. A USDGBP contract would actually give the owner the right to sell GBP1 million and purchase $2 million on December 31st. In the above case, the agreed-upon exchange rate or the strike price would be 2.0000USD per GBP. This kind of contract is a call on dollars but, it is a put-on sterling, and is also called a GBPUSD put, as it happens to be a put on the exchange rate, even though it could be equally called a USDGBP call. If you have absolutely no idea what I’m talking about, you need to brush up on some basics, when it comes to foreign exchange options and the forex market.
If the rate is somehow lower than 2.0000 on December 31st, it would mean that the dollar is much stronger and the pound is a little weaker; then the option can be exercised allowing the owner to sell the GBP at 2.0000. It can immediately be brought back in the spot market at 1.9000, and a profit would be made.