Currency options can be used to trade foreign exchange speculatively as well as to hedge against foreign exchange risks.
Currency options offer some unique features to the foreign exchange trader interested in speculating on future forex rates. By purchasing an option, a trader will know that their downside on the position is limited to the premium they invest upfront. This sounds great, and it is often used strategically to take advantage of anticipated substantial long-term market moves.
Nevertheless, you should also know that the probability of make a profit by purchasing an option will depend significantly upon where the option’s strike price is set at. If the AUD/USD spot exchange rate is at 0.9000 and a trader buys a one month 1.0000 strike AUD call/USD put option, the premium to enter the trade will be small, but the probability of the trader losing it all is actually very high.
On the other hand, traders who sell options receive premium, but they are also exposed to unlimited losses if the market moves against their position and they do not close out the position or otherwise act to stop their losses.
Some traders prefer to buy and sell put or call spreads so that their premium is lower, profits are capped, and their downside risk is known in advance.
Currency options offer some very interesting features for hedging foreign exchange exposures, especially those that have some degree of uncertainty involved, and this is one of the best-accepted uses of options by the corporate treasury. A wide variety of different types of options and option hedging strategies exist to match the full spectrum of risks that companies and fund managers regularly inherit as part of their international trade and investment activities.
For example, a corporation might purchase currency options to protect against a future forex exposure that is uncertain in terms of its size. While this will have an upfront premium cost, the downside is limited and profits may result if the market favours the combination of the purchased option and the resulting currency exposure.
Another company might have a certain exposure combined with a desire to participate in a range of exchange rate movements while at the same time protecting a base rate. They might execute a “range forward” hedge that would involve purchasing a protective option to protect their downside risk and simultaneously selling a covered option to cap their upside potential. This strategy can often be done at no upfront cost, and gives the company a comfortable range of participation.