The value of currencies keeps changing about one another depending on a host of situations – economic growth, political developments, central bank policies, and so on. These fluctuations affect both importers and exporters, whose fortunes depend to a considerable extent of the value of the currency.
To guard against these fluctuations, they use derivatives like currency options and futures. Of course, it’s not just importers and exporters who trade in these. Speculators too are active participants also, hoping to turn in a profit from the movement of exchange rates.
Currency options explained
There are two ways of hedging against currency fluctuations, and these are through options and futures. An option gives you the right, but not the obligation, to buy a particular currency at a specific rate in the future. So there’s a choice here: you can exercise your contract only if you find the price favourable. In currency futures, there is no choice: you have to exercise the right.
Let’s use an example to illustrate how currency options in India work. Information technology company FancyTech (fictitious name) clients are mostly in the USA, and its earnings are in USD. FancyTech expects the value of the INR to increase to Rs 60 from the existing Rs 70 against the USD shortly. This will mean losses since the company has to repatriate its earnings in INR from the USA to India. A stronger INR will translate to less money in its kitty. To offset this, FancyTech decides to purchase currency options that give it the right, but not the obligation, to sell the INR at Rs 70 (`strike price’) against the USD. If the INR does strengthen to Rs 60, it will exercise the right to sell the USD at Rs 70 against the USD through its options. Hence it will be able to hedge against the increase in the value of the INR, and its revenues will remain unaffected.
Let’s say that the INR, weakens to Rs 80 against the Dollar. If FancyTech exercises its option to sell at the strike price of Rs 70, it will suffer losses of Rs 10 for each option. Since it doesn’t make any sense to exercise the contract, it will forgo the right to do so. In that case, the only loss the company will incur is the premium it has paid to enter into the contract.
What is this premium? Well, to enter into any derivatives contract, you have to pay a premium to the seller or `writer’ of the contract. This is generally a fraction of the underlying asset. Premiums are determined by a host of factors like the current currency value, the period between the contract start date and its expiry, and so on.
Types of currency options
There are two types of currency options – the put option and the call option . A put option gives you the right but not the obligation to sell currency at a specific price on a certain date. The above example of FancyTech that we have used is that of a put option. This kind of currency option works best in a scenario where you expect the value of a currency like the INR to strengthen vis-à-vis another currency.
The other type of currency option is the call option, which gives you the right to buy currency at a certain rate. This works when you expect the value of the INR to weaken against another currency like the dollar.
How to trade in currency options
Currency futures were first introduced in India in 2008, followed by options in 2010. Today, the derivatives segment of the National Stock Exchange (NSE) offers trading services in derivative instruments like currency futures on four currency pairs, cross-currency futures and options on three currency pairs. You can purchase currency options on the Indian rupee against other currencies like the euro, pound sterling and the US dollar.
You can purchase call and put options on the USD-INR pair through your stockbroker, or using your online trading platform. The options are European, which means that you can exercise it only on the expiration date. However, you can square off the transaction by selling the options contract back in the market. The difference between the premiums paid for buying and selling would be your net loss or gain.
The lot size of currency options is quite small, at USD 1,000, so it’s easy for retail investors to participate in trading. As we have mentioned earlier, to trade in these, you have to pay a premium to the broker, who then passes it on to the exchange, which is then passed on to the seller of the option or writer.
The premiums are quite low, so this allows you to leverage to a considerable extent and trade in large volumes. This is because you can trade in a multiple of the premium. For instance, if you have to pay a premium of 3 percent, and you trade in Rs 1 crore worth of commodity options, you only have to pay Rs 3 lakh. The large volumes will increase your chances of profit.
Now that you know how to trade in currency options, you can go ahead and do it. Currency futures allow even retail investors to take advantage of changes in exchange rates. The downside is limited since you only stand to lose the premium that you have paid. However, you must understand that currency markets are very volatile, and getting the timing right can be rather tricky.