An option is a contract that gives the holder the right to buy or sell a security at a guaranteed price on a specified date in the future. In the case of foreign currency options, you have the right to buy or sell a specific amount of currency at a pre-determined exchange rate. There are two types of option contracts: calls and puts. A call contract is one where you have the right to buy. A put contract is one where you have the right to sell.
A Canadian dollar put would give you the right to sell Canadian dollars for U.S. dollars at a pre-determined price. You would purchase this kind of contract if you felt the U.S. dollar was going to appreciate against the Canadian dollar. You would buy a Canadian dollar call if you felt the Canadian dollar was going to appreciate against the U.S. dollar. Options are commonly used as a hedging tool. They eliminate the risk of adverse spot market movements. Options are different than futures contracts--another popular hedging tool--as they are rights not obligations. If the adverse price movement never materializes, you don't need to purchase the currency. To take advantage of the insurance aspect of currency options you must pay a premium. The premium is determined by the strike price (the guaranteed exchange rate), market volatility, and time remaining on the contract. A rule of thumb is the premium is higher when: the longer the term, the closer the strike price is to the market price, and more volatile the market. There are two styles of contracts: American and European. An American contract allows the contract holder to exercise the option at any time. A European contract allows the contract holder to exercise the option only upon expiration.
