Options are typically associated with the stock market. However, more recently, these derivatives are widely traded on the foreign exchange market. A forex option, or FX option, is a currency contract that gives the FX option buyer the right, though not the obligation, to buy or sell a particular forex spot contract (the underlying asset), at a defined price (the strike price), on or before the expiration date. The amount paid by the FX option buyer to the seller for the contract rights is referred to as the forex option “premium.”
Consider the example to understand options trading better: You purchase a batch of EUR/USD at 1.5000 for one month. Here, the contract is called a EUR call and a USD put. Note that in the forex options market, you make a call and put simultaneously. If the price of the pair goes below 1.5000, you lose. However, your loss is limited to the amount of premium. If the EUR/USD increases beyond the level, you gain the predetermined amount on selling the option.
How are Premiums on Options Determined?
The premium amount on FX options is affected by several factors, because of which the risk/reward ratio of these options trading varies. Some key factors influencing the price are:
This is the “current” price of the forex option, if it was exercised. The current price may be:
This is reflective of the market uncertainties over time. Generally, a longer option accompanies a higher price.
Interest Rate Differential
An alteration in the interest rates impacts the relationship between the intrinsic value and the strike price. This differential is typically incorporated in the premium, as a component of time value.
A highly volatile market increases the probability of hitting the strike price faster. Typically, volatile currencies accompany higher premiums.