Foreign exchange options are a relative unknown in the retail currency world. Although some brokers offer this alternative to spot trading, most don't. Unfortunately, this means investors are missing out. (For a primer on FX options, see Getting Started in Forex Options.)
TUTORIAL: The Forex Market

FX options can be a great way to diversify and even hedge an investor's spot position. Or, they can also be used to speculate on long- or short-term market views rather than trading in the currency spot market.

So, how is this done?

Structuring trades in currency options is actually very similar to doing so in equity options. Putting aside complicated models and math, let's take a look at some basic FX option setups that are used by both novice and experienced traders.

Basic options strategies always start with plain vanilla options. This strategy is the easiest and simplest trade, with the trader buying an outright call or put option in order to express a directional view of the exchange rate.

Placing an outright or naked option position is one of the easiest strategies when it comes to FX options.

Figure 1: AUD/USD chart showing a double top that is ideal for a put option.
Source: FX Trek Intellicharts

Basic Use of a Currency Option
Taking a look at Figure 1, we can see resistance formed just below the key 1.0200 AUD/USD exchange rate at the beginning of February 2011. We confirm this by the technical double top formation. This is a great time for a put option. An FX trader looking to short the Australian dollar against the U.S. dollar simply buys a plain vanilla put option like the one below:

ISE Options Ticker Symbol: AUM
Spot Rate: 1.0186
Long Position (buying an in the money put option): 1 contract February 1.0200 @ 120 pips
Maximum Loss: Premium of 120 pips

Profit potential for this trade is infinite. But in this case, the trade should be set to exit at 0.9950 – the next major support barrier for a maximum profit of 250 pips.

The Debit Spread Trade
Aside from trading a plain vanilla option, an FX trader can also create a spread trade. Preferred by traders, spread trades are a bit more complicated but they do become easier with practice.

The first of these spread trades is the debit spread, also known as the bull call or bear put. Here, the trader is confident of the exchange rate's direction, but wants to play it a bit safer (with a little less risk).

In Figure 2, we see an 81.65 support level emerging in the USD/JPY exchange rate in the beginning of March 2011.

Figure 2: A support level emerges in the March 2011 USD/JPY pair.
Source: FX Trek Intellicharts

This is a perfect opportunity to place a bull call spread because the price level will likely find some support and climb.Implementing a bull call debit spread would look something like this:

ISE Options Ticker Symbol: YUK
Spot Rate: 81.75
Long Position (buying an in the money call option): 1 contract March 81.50 @ 183 pips
Short Position (selling an out of the money call option): 1 contract March 82.50 @ 135 pips

Net Debit: -183+135 = -48 pips (the maximum loss)

Gross Profit Potential: (82.50 - 81.50) x 10,000 (units per contract) x 0.01 pip = 100 pips

If the USD/JPY currency exchange rate crosses 82.50, the trade stands to profit by 52 pips (100 pips – 48 pips (net debit) = 52 pips)

The Credit Spread Trade
The approach is similar for a credit spread. But instead of paying out the premium, the currency option trader is looking to profit from the premium through the spread while maintaining a trade direction. This strategy is sometimes referred to as a bull put or bear call spread. (Learn more about this and other spreads in Option Spread Strategies.)

Now, let's refer back to our USD/JPY exchange rate example.

With support at 81.65 and a bullish opinion of the U.S. dollar against the Japanese yen, a trader can implement a bull put strategy in order to capture any upside potential in the currency pair. So, the trade would be broken down like this:

ISE Options Ticker Symbol: YUK
Spot Rate: 81.75
Short Position (selling in the money put option): 1 contract March 82.50 @ 143 pips
Long Position (buying an out of the money put option): 1 contract March 80.50 @ 7 pips

Net Credit: 143 - 7 = 136 pips (the maximum gain)

Potential Loss: (82.50 – 80.50) x 10,000 (units per contract) x 0.01 pip = 200 pips
200 pips – 136 pips (net credit) = 64 pips (maximum loss)

As anyone can see, it's a great strategy to implement when a trader is bullish in a bear market. Not only is the trader gaining from the option premium, but he or she is also avoiding the use of any real cash to implement it.

Both sets of strategies are great for directional plays. (For more on directional plays, see Trade Forex With A Directional Strategy.)

Option Straddle
So, what happens if the trader is neutral against the currency, but expects a short-term change in volatility? Similar to comparable equity options plays, currency traders will construct an option straddle strategy. These are great trades for the FX portfolio in order to capture a potential breakout move or lulled pause in the exchange rate.

The straddle is a bit simpler to set up compared to credit or debit spread trades. In a straddle, the trader knows that a breakout is imminent, but the direction is unclear. In this case, it's best to buy both a call and a put in order to capture the breakout.

Figure 3 exhibits a great straddle opportunity.

Figure 3: The volatility of the USD/JPY in February 2011 creates an ideal straddle opportunity.
Source: FX Trek Intellicharts

In Figure 3, the USD/JPY exchange rate dropped to just below 82.00 in February and remained in a 50-pip range for the next couple of sessions. Will the spot rate continue lower? Or is this consolidation coming before a move higher? Since we don't know, the best bet would be to apply a straddle similar to the one below:

ISE Options Ticker Symbol: YUK
Spot Rate: 82.00
Long Position (buying at the money put option): 1 contract March 82 @ 45 pips
Long Position (buying at the money call option): 1 contract March 82 @ 50 pips

It is very important that the strike price and expiration are the same. If they are different, this could increase the cost of the trade and decrease the likelihood of a profitable setup.

Net Debit: 95 pips (also the maximum loss)

The potential profit is infinite – similar to the vanilla option. The difference is that one of the options will expire worthless, while the other can be traded for a profit. In our example, the put option expires worthless (-45 pips), while our call option increases in value as the spot rate rises to just under 83.50 – giving us a net 55 pip profit (150 pip profit – 95 pip option premiums = 55 pips).

The Bottom Line
Foreign exchange options are a great instrument to trade and invest in. Not only can an investor use a simple vanilla call or put for hedging, they can also refer to speculative spread trades when capturing market direction. However you use them, currency options are another versatile tool for forex traders.(For related reading, also take a look at 9 Tricks Of A Successful Forex Trader.)

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