The value of a currency is measured against that of another currency. This value keeps changing all the time because of economic, financial, political and other factors. This kind of fluctuation can affect importers, who like the value of their home country’s to be weak, and exporters, who prefer the opposite.
What is forex options?
To protect themselves against fluctuations in the value of a currency, importers and exporters rely on options and futures. Forex futures gives them the right to buy or sell forex at a specific price at a fixed date in the future. So what is forex options? Well, these give them the right to buy or sell, but not the obligation, to buy or sell currency at a certain price (`strike price’) at a particular date in the future (`expiry date’).
Let’s illustrate this with an example. Let’s take the case of an electronics company HighTech Corp. It imports several components from the USA. If the US dollar (USD) strengthens against the Indian rupee (INR), it will have to pay more for its components, driving up its costs. So the company decides to purchase 10,000 USD forex options at the current exchange rate of Rs 70. When the value of the rupee falls to Rs 75, it will be able to exercise the option and gain Rs 7 lakh, thus offsetting any losses from component imports.
If the USD moves in the opposite direction and the exchange rate now becomes Rs 65, it would not make sense for HighTech to exercise its option since it would incur a loss of Rs 7 lakh. In that case, it will not exercise the forex option. Its losses in this situation will be restricted to the premium it has paid to enter into the contract. Premiums are calculated using a host of factors, but they are generally a small fraction of the underlying. Premiums on these could climb around 3-4 percent. Keep reading to know more about advantages and how to trade forex options.
Advantages of forex options
It’s not just importers and exporters who can benefit. Speculators too can take advantage of the changes in the value of a currency. The low premium makes it possible for them to take much larger positions through leverage. If you want to trade in Rs 1 crore worth of these options, you will only have to pay Rs 3 lakh as a premium to the broker. This enables you to trade in larger volumes, which increase your chances of making a profit.
The most significant advantage of forex options is that, while the upside can be unlimited, the downside is limited to the premium that you have paid. For example, if you purchased 100 USD options at the strike price of Rs 70, and the value of the INR keeps falling, you benefit to the full extent of the fall till the expiry date, even if it goes to Rs 100. In that case, you would have made a windfall of Rs 3,000! On the other hand, if the INR strengthens and reaches Rs 30, you can choose not to exercise your right. So, in that case, your losses will be restricted to the premium paid.
Call and put options
There are two types of forex options – call and put. A call option gives you the right to buy and a put option the right to sell forex options. A call option works better when you expect the value of a currency to fall. A put option works better in a situation where the currency is expected to strengthen.
How to trade forex options
How to trade forex options in India? Foreign currency derivatives are available on Indian exchanges like the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE). You can trade in forex options through your broker or the trading portal/ app. Forex options are available on currency pairs like INR-USD, euro, Japanese yen and Great Britain pound.
Forex options contracts can be executed only on the day of expiry. However, positions can be squared off before that by purchasing or selling put or call forex options. You can get forex options in contract units of USD 1,000, so it’s possible for small traders to benefit from currency fluctuations.