A currency option is a pact that gives the buyer the right, but not the obligation, to trade a specified currency at a given exchange rate during a particular period. For this right, the buyer pays an advance premium in U.S dollars (since trading forex options are traded in terms of U.S dollars).
This upfront amount varies depending on the number of contracts if the option is bought for a nominal amount, on an exchange or if it is done in an over the counter market. This restricts the seller's income to the premium payment while it gives the buyer a theoretically unlimited revenue potential depending on the future direction of the relevant exchange rate.
Individuals, corporations, and financial institutions use foreign currency options to hedge against the possibility of losses that come with exchange rate changes. Forex traders also use them to take speculative positions.
Types of Foreign Currency Option Trading
There are two broad categories of options available to retail forex investors. The most common is the traditional put/call option, which works much like the individual stock option. The other one is "single payment option trading" - or SPOT - which gives forex traders more flexibility.
1. Traditional Foreign Currency Options
The traditional call/put (it is called a call/put because in the options market, buying a call comes simultaneously with a put). Forex options give the buyer the right, not the obligation to purchase something from the option seller at a specified price and period.
In traditional options, traders have the right to choose the price and date the option is to be valid because trade forex options are sold over the counter (OTC). They then receive a quote stating the premium they must pay for the option. Since foreign currency options are quoted in terms of units of foreign currency per U.S. dollar, the premium quote must also reflect in terms of U.S dollar.
There are three types of traditional options available to retail forex traders:
- American option: This option can be exercised on any date within the option period so that delivery is two business days after the exercise date. It is a flexible option since it can be used anytime until it expires.
- European option: This option can only be exercised on the expiry date, which means that delivery will be two business days after its expiry date.
- Bermudan option: The Bermudan option is only exercised on particular predetermined times.
In contrast to single payment option trading, (SPOT) options, traditional options have lower premiums. American premiums allow for more flexibility since they can be bought and sold before their expiration period. Compared to SPOT options, traditional options are more tedious to set and execute.
2. Single Payment Option Trading (SPOT) Options
Under SPOT options, the trader inputs a scenario, obtains a premium (option cost) quote, and then receives a payout if the scenario takes effect. Mostly, SPOT automatically converts the option to cash when the options trade is successful, thus giving the trader a payout.
Besides being easy to execute, SPOT options also offer option forex traders additional choices. These include entering a scenario and letting it play out. In the event you are right, cash is deposited into your account. In case you are not correct, your loss becomes your premium. SPOT options also offer a selection of various scenarios, which allow the forex trader to select an anticipated outcome.
However, higher premiums are a downside associated with spot options. On average, SPOT option premiums cost higher than standard options.
Factors that Affect the Price of Currency Options
- The duration of the option.
- The difference between the current spot price and the designated strike price. The option forex trader can choose a strike price that agrees with his particular circumstances. A strike price that is far away from the current spot price will cost less since the chances of exercising the option are low. However, the forex buyer must be willing to absorb the loss associated with a significant change in the exchange rate before trading forex options.
- The current interest rates for the two currencies involved during the option period.
- The volatility of the market. This is the speculated amount by which the currency is likely to fluctuate during the option period. Higher market volatility increases the possibilities of an option to be exercised. There are no quantifiable ways to predict it volatility, though.
- The willingness of counterparties to issue options.
Why You Should Trade Foreign Exchange Options
- Your downside risk is restricted to the option premium.(Buying price of options)
- Option forex presents the trader with unlimited profit potential.
- You pay less money up front than for a SPOT (cash) forex position.
- If you are trading forex options, you get the chance to set the price and expiration date. (These factors are not predefined like those of options on futures.)
- You can use options to hedge against open spot (cash) positions to limit risk.
- Based on market movements, you can use options to trade without risking much capital before major events take place (such as meetings and economic reports).
Although they can be difficult to use, options represent yet another valuable tool that traders can use to profit or lower risk. Foreign exchange options trading is especially prevalent during critical economic reports or events that cause significant volatility (when cash markets have high spreads and uncertainty.
How to Trade in Foreign Currency
Here are some forex trading tips:
- Start with small amounts you can afford to lose and gradually increase your account with organic gains and not by massive deposits.
- Choose your foreign currency options trading broker carefully.
- Keep your emotions under control by automating your trading as much as possible.
- Recognize, understand, and analyze your objectives and risk tolerance.
- Select your account package per your expectations.
- Begin by concentrating on a single currency pair and expand it as you hone your expertise skills.
- Record your successes as well as your and mistakes.
- Let your long term aims dictate your account choice.
- Trade on what you understand and not on the basis of heresies.
- Do not add to a losing position unless you love gambling.
- Avoid reliance on forex robots and wonder methods
- Do research and find a competent forex options broker to deal with.
As much as trading foreign currency options are a lucrative affair, there is no guarantee that every investor will reap profits. The vast extent of leverage involved can work in your favor or against you. Therefore, before investing in foreign currency options consider your risk appetite, level of experience, your investment objectives and learn the ins and outs on how to trade forex options.
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