In this guide we will explain what OTC currency options are, what they can be used for and the main risks and rewards.
What are OTC FX Options and where can you trade them?
OTC (over the counter) FX Options can help protect you from foreign exchange price fluctuations between two currencies.
Here are the risks, rewards, alternatives, and where you can trade OTC FX Options.
What are OTC FX Options?
OTC FX Options give you the right, but not the obligation to buy a certain amount of currency at a certain price, on a certain date in the future.
This can benefit currency traders because if the currency rates move against your position, you do not have to proceed with the transaction.
They can also benefit those looking to transfer currency internationally as you can benefit if the rates move in your favour.
Advantages and disadvantages of currency option contracts
Advantages of currency options:
- They are very cheap to trade
- They are available on or off exchange
- Risk is limited to premium (if you are a buyer)
- Very high potential returns versus risk
- Lots of strategies to speculate on volatility and price movement
Disadvantages of currency options:
- They can be illiquid
- Quickly become worthless
- Risk is potentially unlimited (if you are a seller)
What are the Advantages of OTC FX Options
Unlike currency forwards where you buy currency for a specific date in the future and are locked into the deal. With OTC FX options, you pay a premium for the right to buy the currency. If you change your mind, you don’t have to. Your risk is limited to the cost of the premium you paid for the option to do so.
What are the risks of OTC FX options?
Although options can be a limited risk financial product there are still downsides.
Firstly, being an OTC (Over The Counter) product there is no centralised exchange, you are contracting with your broker. In most circumstances, the broker will hedge the position and mark up your premium. But the financial security of your broker is something to be considered.
Secondly, if you are buying, an option you risk is limited to the price you’ve paid for your premium. But if you are selling options then your losses are potentially unlimited. So it’s vital that you fully understand what exposure your option may have.
Who should use OTC FX Options
The short answer is only those that understand them. If you don’t, learn about whether they are the right option for you and consider carefully before you commit, speak to a professional currency broker if you are not sure.
If you do they can be a valuable addition to any corporate hedging strategy. Currency traders can use them for speculation and some forex brokers will offer them on an execution only basis. If you are using a currency broker for hedging purposes they may be able to provide you with some strategy advice.
In general, though, currency options should only be used by sophisticated professional investors or corporate clients who fully understand the risks. Also, there are plenty of alleged experts out there who are not properly regulated and claim to have experience. The only brokers that are allowed to offer OTC FX options in the UK are regulated by the FCA. You can check a brokers regulator status on the FCA register here.
Here’s more information on why currency hedging strategies are important.
What are the alternatives to OTC FX Options
If you have some currency exposure you need to hedge there are a few alternatives to OTC FX options.
The first and most obvious being “On Exchange” currency options listed on the CME. However, these are dealt in lot sizes so you don’t get the flexibility of exact trade sizes. But, as they are listed on the CME you do reduce your counterparty exposure.
If you just want to lock in an exchange rate for a future currency transaction you can use a forward contract. These are great for reducing the risk of the exchange rate moving against you. But, if it moves in your favour, then you do not get the benefits. The old adage applies:
In foreign exchange, it’s next to impossible to speculate to make money, but very easy to hedge against losing it…
Here’s more information about what currency forwards are and how they work.
UK Brokers That Let You Trade OTC FX Options
Here is a list of brokers that are regulated by the FCA where you can trade OTC FX options:
There are more details about preparing for a large currency transfer here.
To find out more about your options of OTC with currency brokers, compare currency brokers
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