Whether you’re new to FX trading or an experienced investor, there are many tools to help you take advantage of opportunities in the market. One of these tools is FX Options which can help you hedge currency risk while reducing your overall costs.
Investing in FX Options is similar to investing in other options, such as equity or stock index options. You buy a call or put option contract that gives you the right but not the obligation to sell or buy a specific amount of a given currency pair at a certain price (the strike) on or before the expiry date. You can also use options to hedge a foreign exchange position, which is a common reason for investors to purchase options.
Hedging Foreign Currency Exposure
Companies that have international trading or supplier relationships can be impacted by changes in the exchange rate of a particular currency. These shifts can make the bills that companies need to pay to overseas suppliers go higher than expected, even if the change is relatively small. To mitigate these risks, many companies choose to hedge their exposure by purchasing an FX option, such as an EUR/USD put or call, to lock in a price at which they will be able to make the payment.
The Options Marketplace
CME Group offers a range of flexible FX options that are suitable for investors with a wide variety of investment horizons and objectives. For example, a US-based portfolio manager may have an investment horizon of two years and be exposed to the risk that the EUR/USD exchange rate will remain stable for that period.
For this purpose, he can utilize CME FX options to enhance his returns by selling EUR/USD call options if the exchange rate remains stable for his investment horizon.
He can also use these options to hedge the FX risk of a non-US dollar denominated equity or fixed income portfolio by purchasing a EUR/USD put option.
FX Options come with a higher premium than spot forex and FX forwards, but they are more liquid and have lower risks. This is because you can only lose your initial option premium if the trade doesn’t go your way.
A number of factors affect the options market, including interest rates, inflation expectations and geopolitics. For example, the Federal Reserve’s policy decisions can have an effect on the value of a currency. The markets also depend on economic data, such as unemployment and GDP.
Options can provide you with a greater degree of flexibility than other hedging instruments, such as Spot and Forward contracts, because you have the option to exercise the option at any time before the expiry date. This is particularly useful for hedging when the direction of movement in the markets is uncertain.
It’s important to understand that hedging with currency options can have a significant impact on your company’s capital structure and should be treated as such. For this reason, it’s essential to seek independent advice from a qualified financial advisor before making any decisions regarding currency options or foreign exchange transactions.