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Buy Foreign Currency Options
The most common reason for businesses to buy foreign currency options is to hedge currency risk in international transactions. In these cases traders confine their trades to the specific currencies to be used in a business transaction. On the other hand speculators buy foreign currency options in search of profits. Each reason to buy foreign currency options dictates options trading strategy.
Hedging Currency Risk
The reason that there is a worldwide set of Forex markets is to facilitate international transactions. When the USA went off of the gold standard in 1971 there was no longer that benchmark to compare values of currencies. The Forex market handles transactions of currencies worth trillions of dollars. In fact roughly eighty-five percent of all transactions involve the US dollar. The Forex market sets a fair value for one currency versus another but that relative value fluctuates with both market fundamentals and ever-varying market consensus. The risk inherent in an international transaction is that the relative value currency of the buyer will fall between the agreement on a contract and time for payment. Companies buy foreign currency options to lock in a price that they will have to pay for the currency in which they will need to make payment upon delivery of a product. They buy call options on the payment currency with their own currency.
Buying Forex Calls to Hedge Risk
As an example, a call contract on the Euro using US dollars gives the purchaser the right to buy Euros with dollars at a set price on or before the expiration date of the options contract. In this case, if the US dollar falls in relation to the Euro the buyer of the call option will execute the contract and buy Euros with dollars at the contract price. If the US dollar rises in price the buyer simply lets the contract expire and uses his now-more-valuable dollars to get a better deal in Euros for his purchase.
Speculating in Currency Options
The old saying is that there is always a profitable market somewhere. Currency speculators look for volatile currency pairs and seek to profit from price changes. As with hedging risk the trader can buy calls on one currency with another but he or she has a wider range of currencies from which to choose. Additionally, a currency speculator has no obligation to pay for a product on any future date. Thus, he or she can simply exit a trade when it shows a profit.
Speculators often buy currency options because of options trading leverage. As an example...