Forex option otherwise known as currency option, is a contract that gives the holder the right, but not the obligation to buy or sell a specified currency during a specific time period. It can be used as a protection against a possible financial loss in a forex transaction. It is also a method used by companies that trade goods overseas to reduce risks.
There are two basic types of forex option: Call options and Put options.
A call option gives the holder the right to buy a currency while a put option gives the holder the right to sell.
The worth of an option at expiry is equal to the value realised by the holder in exercising the option. If the holder gains nothing, the option is worth nothing. The value at any other time of the contract duration is the 'intrinsic value' – this is the value that can be realized if the holder exercises his option.
Intrinsic value is linked to the 'strike price' – this is the value specified by the option contract. A call option has intrinsic value if the spot (current) price is above the strike price. A put option has intrinsic value if the spot price is below the strike price.
If the forex option contract has intrinsic value it is said to be 'in the money', otherwise it is 'out of the money' or 'at the money' (at par). Options are generally exercised only if they are in the money.
Options are priced according to formulas that take into consideration both the spot value and time value. Time value is calculated according to expected market conditions including volatility and the difference in interest rates between the two currencies. Options must be priced low enough to attract potential buyers and high enough to attract potential writers (the sellers or guarantors of the option).