Options are usually associated with the stock market, but the foreign exchange market also uses these derivatives in trading. It gives traders the opportunity to make money at a risk he has set for himself. To understand this concept better, let us use the example of purchasing a car.
If you hold a contract that requires you can buy a certain car on May 1st at a price of $1,500, you have an option to buy the car. This option ensures that if the value of the car increases at the predetermined time of purchase (in this case on May 1st), then you will profit from it because you can sell the car to another person for more than the amount you originally paid for.
On the other hand, if the value of the car decreases from the original amount, it wouldn’t be beneficial to buy that car. The option gives you the right to buy, in this case, the car but not the responsibility to pay for it if you don’t want to. This significantly lessens the risks to the trader. There are basically two types of options available to retail traders. These include the traditional call/put option and the single payment option trading (SPOT) trading.
The traditional call/put option works very much like the stock option. It gives the buyer the right (but not the obligation) to buy from the option seller at a specified time and price. For example, a trader can purchase the option to buy four lots of EUR/USD at 1.4000 for a certain month (this contract is called a EUR call/USD put). Remember that in the options market, you buy a call and a put at the same time. If the price of the EUR/USD goes below 1.4000, then the buyer loses the premium. But if the EUR/USD increases to 1.6000, then the buyer can use the option and gain the four lots for the agreed upon amount and sell it at a profit.
The Forex option are traded over-the counter. Because of this, Forex traders can easily choose the price and date of their preferred option. They will receive a quote regarding the premium they need to pay in order to get the option. There are two kinds of traditional options available today:
American Style Option
Can be used at any point until the expiration date
European Style Option
Can only be used at the point of expiration
Probably the main advantage of traditional call/put option over its counterpart is the fact that it requires lower premium. In addition, because the American-style option allows it to be traded even before expiration, forex traders gain more flexibility. On the downside, traditional options are requires more work to set and execute compared to SPOT options.
SPOT options have almost the same concept as traditional options. The main difference is that the forex trader will first give a scenario (UER/USD will break 1.4000 in 2 weeks), gets a premium, and then receive cash if his scenario occurs. SPOT trading converts the option to cash automatically if your trade is successful. This type of option is very easy to trade because it only requires you to enter a scenario and then wait for the results.
Essentially, if your scenario plays out, you receive cash. But if it is incorrect, you will shoulder the loss of the premium. Another advantage of the SPOT option is it allows a wide variety of choices for the trader. He can choose the exact scenario that he thinks will play out. The main downside of the SPOT premium is that it is higher. In general, it costs significantly more than its counterpart.
There are a lot of reasons why SPOT options appeal to a lot of investors and forex traders. Among its many benefits include:
But if options have all these benefits, why isn’t everyone into this type of forex trading? It is important to recognize that it does have its downsides as well.
As was mentioned earlier, the premium price can vary because of several factors. This is why the risk/reward ratio of forex options trading varies. Some of the factors that determine the price are:
This is the current price of the option if it was used. The position of this price against the strike price can be described in three ways such as “in the money” (when the strike price is higher than the current value), “out of money” (the strike price is lower than the current value), and “at the money” (the strike price and the current value are at the same level).
This reflects the uncertainty of market movements over time. In general, the longer the time period of the option, the higher the price you have to pay.
Interest Rate Differential
A change in the interest rates has an impact on the relationship between the strike price and the current market value. This differential is often included in the premium as part of the time value.
High volatility increases the probability that the market price will hit the strike price in a certain timeframe. Volatility is often included as part of the time value. Usually, volatile currencies require higher premiums.
Options offer another opportunity for traders to make a profit with lower risks involved. Forex options, in particular, are prevalent during periods of political uncertainty, important economic developments, and significant volatility. It is up to the trader whether he will take advantage of the opportunity presented by forex options or not.