Forex Options
Forex OptionsForex Options Explained
You probably know what the term "options" means when it comes to the stock market, and you might know what Forex trading is as well. However, what does the term "Forex options" meaning as it specifically relates to the Forex market? Let's discuss what options are as they pertain to the Forex market.
What are Forex options?
A Forex or foreign exchange option gives one person the right (although he or she is not obligated to carry out that "right") to exchange one monetary denomination (for example, British pounds sterling) for another monetary domination (for example, US dollars), at a predetermined or pre-agreed-upon exchange rate, and at a set time. With this type of setup, you are exercising both a "put" option and a "call" option at the same time. (A "put" option gives you, the owner of the security, the right but not the obligation to sell a security at a predetermined price and time to a buyer, and a "call" option gives a foreign exchange options buyer the right but not the obligation to purchase a specific previously determined currency at a predetermined price and time from the owner.)
For example, let's say that you decide to buy one million British pounds sterling and sell 2 million US dollars on a specified date, say October 31. In this case, you are agreeing to exchange two US dollars for every one British pound sterling you receive. Now, again, remember that you have the right but not the obligation to do this exchange. So, when October 31 arrives, if you find that you would actually pay less than two US dollars for every British pound sterling, you would exercise that option, because the dollar is stronger and the British pound weaker, and you'll make money with this option. If, however, the reverse is true and the British pound is stronger at the dollar is weaker, you have the option to abstain from doing that particular exchange.
Actually making the trade
Forex options are traded over-the-counter, or OTC, and if you as a trader want to participate, you choose the price and date you want your particular option to be valid, and then you'll receive a quote with a premium; you have to pay that premium in order to get the option, or the ability to make the trade on that specified date.
"Puts" and "calls"
In Forex options trading, there are two particular parts to a trade, the "put" option, and the "call" option. However, they are each separate trading processes, not two parts of a single trading process. That is, there has to be a put seller for every put buyer, and there has to be a call seller for every call buyer. The options buyer pays a fee or premium to the seller with every options transaction.
What types of options are there in Forex option trading?
There are two basic types of options available to you as a Forex trader. The first is the traditional combination call/put option, as explained above, while the other is what's called "single payment option trading," or SPOT. This second type gives you more flexibility.
Are traditional options better than "SPOT" options?
It depends on the situation as to whether traditional options are better than SPOT options. Traditional options usually have lower premiums than spot options do. In addition, traditional options, which are also called American options (more on that explained below), are more flexible than other types of options, because you can buy and sell them before the expiration date if you choose. However, it's also much more difficult to set and execute them than SPOT options.
Other variations in traditional options set ups as offered by brokers:
With Forex trading options, there's also another variation, and that is the style of option offered. Most Forex option trades are done in either American or European style. With American-style options, you can exercise your option at any time before the expiration date set on the trade. With European style options, you can only exercise your option ON the expiration date. Most of the time, it's best to hold onto an option until its maturity (even if it is an American-style option), although there are times when it may be advisable to exercise the option earlier.
What are the advantages of engaging in Forex option trading?
There are several advantages to traders who want to trade in traditional Forex options. For one, risk is relatively limited, since you're only risking the option premium paid, or the amount of money paid to purchase the option. Profits are potentially unlimited, and of course you're going to pay less with traditional trading than you will for SPOT trading. You get to set both the price and the expiration date, unlike predefined terms of options on futures.
You can also hedge against cash positions to limit your risk and you don't have to use a lot of capital if you want to use options to trade on predicted market movements before certain events take place (like economic reports).
However, there are risks with Forex options trading as well. Your premiums are going to vary, depending on the trade itself, and you can't trade SPOT options once you buy them. Options trading also in effect has you "betting" on what future market movements will be in terms of time and price, and those predictions can be wrong.
In short, only you can decide whether or not you should engage in Forex options trading, but it can certainly be an exciting and lucrative way to make money. Once you know the market well enough and understand the processes well enough, it may be something you want to try your hand at. There's a lot more to learn about Forex options trading, too, than can be explained in one brief article. So take some time, do some research, and decide whether Forex option trading may be something you want to try.
