We know what listed stock options are (versus the kind given to overpaid executives as compensation). They’re contracts to buy or sell 100 share of stock at a given price, within a given time frame.
But there are other kinds of options out there. One of them involves a similar model – derivative financial instruments in the form of contracts to exchange US dollars for foreign currency at a given exchange rate, and within a given length of time.
Betting on the Foreign Exchange Rate
If the exchange rate moves in a positive direction for the US investor, she or he makes money, because they can exchange the stated amount of US dollars at a rate that is more than the going market rate. And vice versa.
These are called Forex options, for foreign exchange options, or FX option, even currency option). The market for these options is huge, one of the largest for options of any kind. They are traded over the counter and are lightly regulated, though some do trade on such exchanges as the Philadelphia Stock Exchange and the Chicago Mercantile Exchange.
The contracts are all futures, and their annual trading value approaches $200 trillion annually.
A Familiar Vocabulary
Like stocks, the contracts come as calls (the right to buy money at a stated exchange rate) or puts (the right to sell money at a stated exchange rate, called the strike price). The contract calls for specified number of dollars to be exchanged for a specified number foreign denominations, virtually from any active currency in the world.
These terms – put, call, strike price – are precisely those used on stock options exchanges, and the mechanics work in a nearly identical manner.
Large corporations doing business abroad use Forex options to hedge the value of certain contracts entered into now, but with future payments associated with it. For example, if a price is determined at today’s rate, but the rate turns unfavorable months later when subsequent payments are due, the company can ensure an equitable outcome by hedging the amount involved with these options.
Lately, though, Forex trading has become popular with individual speculators. As with other types of futures contracts, this is because of the advent of the personal computer and its ability to make real time data accessible and accurate, not to mention virtually free.
But as with options and commodities, this is no place for the beginner or the timid. The action is fast, and the leverage can mean significant consequences with only a slight movement in the market.
