Currency options also known as forex options are used in forex trading to minimize risk against unexpected moves in the market. If you buy an option, your losses are limited to the cost of the option. The sellers of options are more vulnerable. They gain the premium but they are exposed to unlimited loss if the market moves against them.
It is used as a hedging tool. There are many different types of currency options available. They are often used by companies that trade overseas to minimize the potential for loss due to fluctuations in the foreign exchange market.
Forex trades have a special type of option available known as a Digital Option. This option pays a specified amount at expiration if the criteria are met, but if the criteria is not met then it pays nothing.
Forex traders who wish to use a digital option first check and decide which direction the currency exchange market is moving. They then decide on a payoff amount if the market moves as expected within a certain time frame. With this information the cost of the option can then be calculated, as shown below. For example:
The price of the euro is currently trading at about 1.2400 and you expect it to rise to 1.2800 within 3 months. You decide to buy a put digital option with a payoff of $5000. The cost of the option is $800.
If at the end of this 3 months the euro is more than 1.2800 you get $5000. If the price is less, you lose $800.