A currency option is a contract between a buyer and a seller that gives the buyer
the right, but not the obligation, to trade a specific amount of currency at a predetermined price
and within a predetermined period of time, regardless of the market price of the currency; and
gives the seller, or writer, the obligation to deliver the currency under the predetermined terms, if
and when the buyer wants to exercise the option. More factors affect the option price relative to
the prices of other foreign currency instruments. Unlike spot  or forwards, both  high and low
volatility may generate a profit in the options market.

For some, options are a cheaper vehicle for
currency trading. For others, options mean added security and exact stop-loss  order execution.
Currency options constitute the fastest-growing segment of the foreign exchange market. As of
April 1998, options represented 5 percent of the foreign exchange market. (See Figure 1.4). The
biggest options trading center is the United States, followed by the United Kingdom and Japan.
 
Options prices are based on, or derived from, the cash instruments. Often, however, traders have
misconceptions regarding both the difficulty and simplicity of  using options. There are also
misconceptions regarding  the capabilities of options.

 Trading an option on currency futures will
entitle the buyer to the right, but not the obligation,  to take physical possession of the currency
future. Unlike the currency futures, buying currency options does not require an initiation margin.
The option premium, or price, paid by the buyer to the seller, or writer, reflects the buyer's total
risk. However, upon taking physical possession of the currency future by exercising the option, a
trader will have to deposit a margin.

 
The currency price is the central building block, as all the other factors are compared and
analyzed against it. It is the currency price behavior that both generate the need for options
and impacts on the profitability of options.