As Brexit continues to batter the currency markets, companies now more than ever need to protect their exposure to foreign exchange price fluctuations. One method, that is often ignored, is OTC FX Options.
We’ll take a look at what they are, the risks, rewards, alternatives and where you can trade OTC FX Options.
What are OTC FX Options?
In a nutshell, an OTC FX Option gives 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.
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, don’t.
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 then 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 charlatans out there who are not properly regulated and claim to be experts. 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.
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 counter-party 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…
Where can you trade OTC FX options?
Here is a list of brokers that are regulated by the FCA where you can trade OTC FX options:
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Richard started the Good Broker Guide in 2015 and has been a broker for 20 years most recently at Investors Intelligence and previously a multi-asset derivatives broker at MF Global (Man Financial). Richard started his career working as a private client stockbroker at Walker Crips and Phillip Securities (now King and Shaxson) after interning on the NYMEX oil trading floor in New York and London IPE in 2001 & 2000.