Currency Options

Forex option is a contract that conveys the right, but not the obligation, to buy or sell a particular item at a certain price for a limited time. Only the seller of the option is obligated to perform.
Simply stated, a buyer of a currency option acquires the right - but not the obligation - to buy (a “call”) or sell (a “put”) a specific amount of one currency for another at a predetermined price and date in the future. The cost of the option is called a ‘premium’ and is paid by the buyer to the seller. The seller determines the price of the premium at which they are willing to grant the option, based on current rates, nominated delivery and expiry dates, the nominated strike rate and option style.
It is entirely up to the buyer whether or not to exercise that right; only the seller of the option is

obligated to perform.

Call Option:

Call Option - an option to BUY an underlying asset (stock or currency) at an agreed upon price (Strike Price or Exercise Price) on or before the expiration date. Since this option has economic value, you have to pay a price, called the Premium.
Example: Microsoft (MSFT) was recently selling at $29.50/share, and there were 4 different options. For example, for $1.00 (premium) you could buy one call option that would allow you to buy a share of MSFT for $30 (strike P) on or before January 16, 2005. You will exercise the option if P > $30, and you will make money if the P > $31.00 ($30 + $1.00). If P = $30, you will not exercise the option, it will expire worthless and you will lose the premium ($1.50).
Next example shows two ways to calculate profit from call option:
You have paid a premium of $187.50 in July that gives you the right to buy SF @ $0.67 on or before September 10. If the SF sells at $.7025 on expiration, you can exercise your right to buy @$0.67 and then sell at $0.7025, for proceeds of $2,031.25. Subtracting the cost of your option premium of $187.50, you have a net profit of $1,843.75 ($2,031.25 - $187.50). The writer (seller) of the call option would lose $1,843.75.

1. Profit = S - (Exercise Price + Premium) x SF62,500
Profit = $.7025 - ($0.670 + $0.003) = $0.0295/SF x SF62,500 = $1,843.75

2. Profit = (S - Exercise Price) x SF62,500 - PREMIUM
Profit = ($0.7025 - $0.67) x SF62,500 = $2,031.25 - $187.50 = $1,843.75

ROI:

Your return on investment (ROI) would be $1843.75 / $187.50 (Profit / Investment) = 983% for 2 months! Illustrates leverage. You control about $42,000 worth of SFs (SF62,500 x $.67/SF) with only $187.50, or less than 1% of the underlying value of the currency.
If spot rate at expiration is only $.6607/SF (or any rate < $.67/SF), the option expires worthless, you lose the premium of $187.50, which would be the gain to the writer (seller) of the call.
Note: If the spot rate was between $.67 and $.673, you would exercise, but lose money. For example, if S = $0.671, you would lose ($.671 - .673) x SF62,500 = -$125 by exercising, vs. -$187.50 without exercising.
Like futures trading, option trading is a zero-sum game. The buyer of the option purchases it from the seller or the person who "writes" the call. Options are traded in units of 100 shares.

Put Option:

Put Option - gives the owner the right, but not the obligation to sell an underlying asset at a stated price on or before the expiration date.
Example: MSFT $30 January 2005 puts were selling for $2 (premium). You will make money if the P < $28. You will exercise if P < $30, exercise but lose money if P $28-30. If P > $30, put will expire worthless.
The option extends only until the expiration date. The rate at which one currency can be purchased or sold is one of the terms of the option and is called the exercise price or strike price. The total description of a currency option includes the underlying currencies, the contract size, the expiration date, the exercise price and another important detail: that is whether the option is an option to purchase the underlying currency - a call - or an option to sell the underlying currency - a put.
A Currency Option is a bilateral contract between two counterparties, and therefore each party is responsible for assessing the credit standing and capacity of the other party, before entering into a transaction.

There are two types of option expirations -

American-style

European-style

American-style options can be exercised on any business day prior to the expiration date. European-style options can be exercised at expiration only.
Currency options give the holder the right, but not the obligation, to buy or sell a fixed amount of foreign currency at a specified price. 'American' options are exercisable at any time prior to the expiration date, while 'European' options are exercisable only on the expiration date. Most currency options have 'American' exercise features. Call options give the holder the right to buy foreign currency, while put options give the holder the right to sell foreign currency.
Call options make money when the exchange rate rises above the exercise price (allowing the holder to buy foreign currency at a lower rate), while put options make money when the exchange rate falls below the exercise price (allowing the holder to sell foreign currency at a higher rate). If the exchange rate doesn't reach a level at which the option makes money prior to expiration, it expires worthless – unlike forwards and futures, the holder of an option does not have an obligation to buy or sell if it is not advantageous to do so.
Other types of currency options:

Average Rate Option

Unlike a conventional option, which is settled by comparing the strike with the spot rate at expiration, an average rate option is settled by comparing the strike with the average of the spot rate over the option period. This hedges against price movements without locking in a fixed price or rate upfront. The average can be geometric or arithmetic and can begin at any point during the option period. The sampling process frequency and interval of underlying price observations can be tailored to suit the user.
Unlike a straight American or European-style option, an average rate option can be settled more than once over its life. So for example, the holder of a one-year average rate option can choose to settle the option monthly versus the average price or rate of the underlying the previous month. Average rate options are cheaper than conventional options because the averaging process smooths out the underlying price movements thereby reducing volatility and hence the premium of the option. Typically the volatility of an average rate option is about half the volatility of a conventional option. Also known as an Average Price or Asian option. Averaging has been applied to a wide range of swaps and options.

Average Strike Option

An Average strike option is similar to a standard option except that the strike price is taken to be the arithmetic average of the price of the underlying asset during the life of the option.
Currency options were originally traded OTC (dealer network), not on organized exchanges. Currency traders were intl. banks, investment banks, brokerage houses.
Options in OTC can be customized for the traders - maturity, contract size, exercise price, usually in large amounts of $1m, the size of most currency trades in the spot market.
Since 1982, currency options have been traded on the Philadelphia Stock Exchange, see Exhibit 9.6 on p. 210 for contracts. Option contract sizes are half of the futures contracts, e.g., £31,250 instead of £62,500, approx $56,000. Contracts are traded on a March, June, Sept, Dec cycle with original maturities of 3, 6, 9, 12 months. In addition, one and two month contracts are also traded so that there are always 1, 2 and 3 month contracts. Also, long term option contracts are traded for 18, 24, 30, 36 months.
OTC trading dominates currency options trading on the Philadelphia exchange, $60B/day OTC vs. $1.5B/day for exchange-traded contracts. See WSJ story on p. 211. Big currency traders (banks) prefer OTC market, it operates 24 hours/day (necessary now in global market - time zone differences in Asia, Europe/currency crises), contract size is much bigger ($1m vs. $45,000 avg. PHLX), more efficient, lower transactions cost. PHLX limits traders to 100,000 max contracts. Also, trading is thin in exchange-traded currency derivative markets (3% of worldwide total), so prices tend to be less reliable, more volatile. For a $100m trade, it would be cheaper OTC vs. exchange trade.