A foreign exchange option (usually shortened to currency option or FX option) is a type of financial instrument called a derivative. Forex options give the holder of the option the right to purchase a currency at a pre-determined exchange rate. The holder of an FX option is not obliged to buy the currency. The FX options market is by far the most liquid options market in the world. Usually options are traded OTC (over the counter) – in other words, directly between two parties so FX options are lightly regulated.
When you think about an option you think about obtaining the right to buy something; for example, taking out an option on oil means you can purchase oil at a set price at a future date. However FX options are more symmetrical in the sense that it is an exchange. A USD/EUR option means you have the right to exchange your US Dollars for Euros at a pre-fixed rate.
Corporations primarily use FX options to hedge against exchange rate fluctuations. Fluctuating exchange rates can mean that a company needs to pay more for raw goods while it gets less for the goods it sells. Using options a company can hedge against the possibility of a currency moving in the wrong direction.
Speculators, especially a day forex trader, prefer trading FX options instead of actual currency. Because they speculate on intra-day currency movements day traders have no need to actually hold or own the currency, whereas a long term currency trader ‘buys’ a currency and keeps it for later sale.