Just as you can purchase stock options in the stock market, you can purchase currency options in the FOREX market. An option gives you the right to buy or sell a currency in a specified time frame, but does not obligate you to do so. Currency options are often used to minimize risk. As in the stock market, there are call options and put options. A put option gives you the right to sell, and a call option gives you the right to buy.
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What is an option worth? It is worth the value that the holder of the option realizes while exercising the option. The intrinsic value, however, is the value of the option at anytime the holder is not exercising the option, but the profit or loss that may be realized if the option was in fact exercised.
The strike price is the value of the currency in the option contract. If the current, or spot price of the currency is below the strick price, a put option has intrinsic value. If it is above the strike price, a call option has intrinsic value. If there is intrinsic value in an option contract, it is ‘in the money.’ Options are typically exercised when they are in the money.
There is a very complicated formula for figuring the price of a currency option. The spot value and the time value must both be considered. The time value is determined by looking at the expected market conditions and the difference in interest rates between the two currencies. The spot value, of course, is the current price of the currency. The seller or guarantor of an option is called a writer.
Purchasing a currency option can protect you against loss in the event of unexpected market moves. If the market moves in a way that works against the option, your only loss is the cost of the option. Selling an option, however, works the opposite way, as sellers are open to unlimited loss.
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A currency option is basically a hedging tool, and there are numerous types of options that are available. A special type of option in the FOREX market is the Digital Option. This type of option pays nothing if certain criteria are not met, but pays a specified amount if the requirements are met.
Many agree that these are the safest and least complicated types of options, but before you use a digital option, you must first determine which way the market is going. A time frame must be determined, as well as the payoff. This is how the cost of the option is determined.
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Here is a prime example of a digital put option: The price of the USD is currently at 1.1500. You expect it to go up to 1.1900 in two months. The price of the option is $800, and the payoff is $5000. Now, if the USD does in fact go up, as expected, you get $5000 at the end of those two months, but if it doesn’t, you are out the $800 you paid for the option.