Depending on the selection of buying or selling the numerator or denominator of a currency pair, the derivative contracts are known as futures and options.
There are various ways to earn a profit from futures and options, but the contract-holder is always obliged to certain rules when they go into a contract.
There are some basic differences between futures and options and these differences are the ways through which investors can make a profit or a loss.
Long and Short Currency Trading
Currency futures and options are derivative contracts. These contracts derive their own values from utilization of the underlying assets, which, in this case, are currency pairs. Currencies are always traded in pairs.
For example, the Euro and U.S. Dollar pair is expressed as EUR/USD. When someone buys this pair, they are said to be going long (buying) with the numerator, or the base, currency, which is the Euro; and thereby selling the denominator (quote) currency, which is the Dollar. When someone sells the pair, it is selling the Euro and buying the Dollar. When the long currency appreciates against the short currency, people make money.
Foreign Currency Futures
Currency futures make the buyer of the contract to buy the long currency (numerator) by paying with the short currency (denominator) for it. The seller of a contract has the reverse obligation. The obligation of the contact is usually due on the expiration date of the future.
The ratio of currencies, bought and sold, is settled in advance between the parties involved. People make a profit or loss depending on the gap between the settled price and the real, effective price on the date of expiration.
Margins are deposited for the futures trades – cash is the important part that serves as the performance bond to make sure that both parties are obliged to fulfil their obligations.
Options on Currency Pairs
The party that purchases a currency pair call option may also decide to settle for an execution or to sell out the option on or before the date of expiration. There is a strike price of the option that shows a particular exchange ratio for the given pair of currencies.
When the actual price of the currency pair is more than the strike price, the call holder earns a profit. It is said to execute the option by buying the base and selling the quote at a profitable term. A put buyer always bets on the denominator or quote currency appreciating against the numerator or the base currency.
Options on Currency Futures
Instead of having to buy and sell currency pairs, options in a currency future offers the contract-holders the right, but not an obligation, to purchase a futures contract on the particular currency pair.
The strategy in such a case is that the option buyer can profit from the futures market without having to put down any margin in the contract. When the futures contract appreciate, the call or contract holder can just sell the call for a profit. The call holder does not need to buy the underlying futures contract. A put buyer can easily earn a profit if the futures contract loses value.