Fx options vs forwards

How does a forward contract differ from a call option? (AAPL)

Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets at specified prices on future dates. Forward contracts and call options can be used to hedge assets or speculate on the future prices of assets.

Explaining the Differences Between Forward Contracts and Call Options.

A call option gives the buy or holder the right, but not the obligation, to buy an asset at a predetermined price on or before a predetermined date, in the case of an American call option. The seller or writer of the call option is obligated to sell shares to the buyer if the buyer exercises his option or if the option expires in the money.

For example, assume an investor purchases one call option contract on Apple Incorporated (AAPL) with a strike price of $130 and an expiration date of July 31. The call option gives the investor the right to purchase 100 shares of AAPL on or before July 31. Assuming AAPL is trading at $135 on July 30, the call option is considered in the money and the investor could exercise his right to buy 100 shares of AAPL for $130. Thereafter, the investor could sell his shares of AAPL for $135 per share.

Contrary to call options, forward contracts are binding agreements between two parties to buy or sell an asset at a specific price on a specific date. For example, assume two parties agree to trade 100 troy ounces of gold at $1,100 per troy ounce on Dec. 31. One party who enters into this agreement is obligated to buy 100 troy ounces of gold, while the other party is obligated to sell 100 troy ounces at a price of $1,100 per troy ounce. Unlike a call option, the buyer is obligated to purchase the asset. The holder of the contract cannot choose to exercise the option and allow the option to expire worthless.

What is the difference between trading currency futures and spot FX?

The forex market is a very large market with many different features, advantages and pitfalls. Forex investors may engage in currency futures as well as trade in the spot forex market. The difference between these two investment options is very subtle, but worth noting.

A currency futures contract is a legally binding contract that obligates the two parties involved to trade a particular amount of a currency pair at a predetermined price (the stated exchange rate) at some point in the future. Assuming that the seller does not prematurely close out the position, he or she can either own the currency at the time the future is written, or may "gamble" that the currency will be cheaper in the spot market some time before the settlement date.

Spot FX, Forward FX, Futures FX, and Options FX.

When we refer to the Forex market we usually refer to the Spot FX or Spot Forex market. The Spot FX is a large Over The Counter (OTC) market that consists of thousands of Interbanks, institutional investors/traders, brokerage firms, and millions of retail traders. This market refers to the cash market of Forex. Although the Spot FX contracts settle within 2 days of the contract they are based on the current global price of the currencies. What you actually pay to purchase a currency against selling the other is the manipulated price by your market maker which is usually a brokerage firm.

A Forward FX contract refers to a future price of a currency pair. For example the price in 7 days from now. Such contracts are still Over The Counter meaning that there is no official exchange or clearing house for them.

A Futures FX contract is similar to a forward contract. However, it is traded on an exchange such as Chicago Mercantile Exchange (CME) in USA or Montreal Exchange (or rather Bourse de Montréal) in Canada.

An Option FX gives the buyer of the contract the right but not the obligation to buy or sell a specific volume of a currency pair at a specific price within a specific time frame (for example in the next 3 months). You may trade Option FX contracts on an exchange or Over The Counter.

The rules that govern exchange traded Option FX and Futures FX contracts could vary from country to country or even from exchange to exchange.

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Difference Between Foreign Currency Options & Futures.

Futures and options are two different ways to trade currencies.

Currency options and futures are both derivative contracts – they derive their values from the underlying asset -- in this case, currency pairs. Currencies always trade in pairs. For example, the euro/U. S. dollar pair is denoted as EUR/USD. Buying this pair means going long, or buying, the numerator, or base, currency --the euro -- and selling the denominator, or quote, currency -- the dollar. If you sold the pair, these relationships would be reversed. You make money when the long currency appreciates against the short currency.

Foreign Currency Futures.

Currency futures oblige the contract buyer to purchase the long currency and pay for it with the short currency. The contract seller has the reverse obligation. The obligation comes due on the futures expiration date, and the ratio of bought and sold currencies is agreed to in advance. The profit or loss arises from the difference between the agreed price and the actual price on the expiration date. Margin is always deposited for futures trades – it is cash that acts as a performance bond to ensure both parties fulfill their obligations.

Options on Currency Pairs.

The buyer of a currency pair call option may decide to execute or to sell the option on or before the expiration date. The option has a strike price that denotes a particular exchange ratio for the pair. If the actual price of the currency pair exceeds the strike price, the call holder can sell the option for a profit, or execute the option to buy the base and sell the quote on profitable terms. A put buyer is betting on the quote currency appreciating against the base currency.

Options on Currency Futures.

Instead of having an option to buy and sell currency pairs, an option on a currency future gives holders the right, but not obligation, to buy a futures contract on the currency pair. The strategy at play here is that the option buyer can benefit from the futures market without putting down any margin. Should the futures contract appreciate, the call holder can simply sell the call for a profit and need not purchase the underlying futures contract. A put buyer profits if the futures contract loses value.

Differences between Options and Futures.

The main difference is that option buyers are not obligated to actually purchase or sell the long currency – futures traders are. Option sellers may have to buy or sell the underlying asset if the trades go against them. Option buyers need not put up any margin and their potential loss is limited to the purchase cost, or premium, of the option. Option sellers and futures traders must put up margin and have virtually unlimited risk. Finally, the premium of an options contract is almost always lower than the required margin on a similar futures contract.

References.

"Currency Trading in the Forex and Futures Markets"; Carley Garner "Options on Foreign Exchange"; David F. DeRosa "Foreign Exchange: A Practical Guide to the FX Markets"; Timothy M. Weithers.

About the Author.

Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B. S. in biology and an M. B.A. from New York University. He also holds an M. S. in finance from DePaul University.

Photo Credits.

Goodshoot/Goodshoot/Getty Images.

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