Selecting A Hot SPOT Option

Initially used in Europe as another way to trade currency options, single-payment options trading (SPOT) options have gained acceptance in other markets as well. Investors who are learning to invest might consider using them, as they offer investors another way to possibly generate profit and lower risk. If generating profit interests you - and it probably does - read on to learn more about seeing SPOTs. (For more information on currency-trading options, see Getting Started In Forex Options.)

What are SPOT Options?
SPOT options allow an investor to set the conditions that must be met to receive a desired payout. Setting up this type of option involves three steps:

1. The investor defines a trading scenario that, according to their analysis, has the best prospects, including the risk-reward tradeoff.
2. The broker determines the probability the conditions will be met and proposes an appropriate premium. The price of the option or the premium quoted by the broker will depend upon the likelihood of the scenario occurring.
3. The investor can agree to either pay the premium and then buy the option or turn it down. Normally, the price of the option or premium represents a percentage of that payout.

This type of arrangement is often called a "binary option" by many brokers because only two types of payouts are possible for the investor:

• When the conditions set out by both parties occur, the investor collects the agreed-upon payout amount.
• If the conditions do not occur, the investor loses the full premium paid to the broker.

Binary options are vanilla put and call options whose value is set by the conditional scenario, not just the price and the expiration date. (For more on binary options, read Exotic Options: A Getaway From Ordinary Trading.)

The Advantages and Disadvantages
Like most investing techniques, there are advantages when using SPOT or binary options:

• While a bit different from normal options, binary options are easy to trade. With a normal option you might not be able to close out the position, since no one is willing to take the opposite side. With binary options, this is never a problem, since there is never a need to close out the position - it is a one-sided trade.
• Binary options give an investor the opportunity to create different scenarios that allow you to choose exactly what you believe will happen in the market. In fact, investors who use binary options define the specifics of the trade.
• With binary options, the downside risk is limited to the premium paid. (Practical And Affordable Hedging Strategies offers tips on transferring risk.)
• The option scenario defines the reward, so it is known before entering the trade. Before committing to the trade, the investor knows the risk-reward tradeoff. (Read more about balancing risk and reward in The Risk-Reward Tradeoff.)

Binary options also have their disadvantages:

• The premium, the amount you must pay to buy the option, is usually higher.
• Once you have bought a binary option, it cannot be traded to close out the position. Should conditions change, you cannot change your mind and sell the option.
• Your broker determines the premium you will pay based on the factors you set, including the underlying security, the strike price and the expiration date. You can accept or reject the premium payment, but this would only be an advantage if the premium were not higher, as it usually is. (For further reading on the role of a broker, read Brokers and Online Trading: What Does a Broker Do?)
• Investors need to understand that it is difficult to predict the exact time-period and strike price of the scenario you are proposing. This can make it more difficult to achieve the goal of the trade. Fortunately, there are different types of binary options that help to mitigate this disadvantage.

Types Of SPOT Or Binary Options
SPOT options come in many varieties, giving investors flexibility to meet their needs. Here are some of the more common types.

One-Touch
When buying a one-touch option, traders set the expiration date and specific price target they believe the underlying security will achieve to receive the payout. Another type of binary option is the "up/down", where an investor believes a underlying security is going to finish up or down on the previous day's settlement price. If you choose correctly, you are paid; if you are wrong, you lose your premium.

For example, let's say that as a forex trader you are bullish on the EUR/USD currency pair over the next two weeks. In this case you should buy a one-touch SPOT that expires in 10 days.

No-Touch
When buying this type of option, the trader sets the amount of profit that he/she will make if - and only if - an underlying security does not reach the specified price point before a certain time. The further away the price is from the price point, the lesser the payout potential, since there is greater probability that the underlying security will not touch the strike price.

In this case, as a forex trader you believe the EUR/USD will remain flat for the next week. Buying a no-touch SPOT that expires in five days would be the way to go.

Double One-Touch
With a double one-touch option, traders choose two price points and set the profit they will make if either one is hit. Usually, double one-touch options are used when traders expect highly volatile market conditions but don't know what direction the market will take. In this case, double one-touch options are similar to long straddle or strangle options. (Read more about straddles and strangles in Straddle Strategy A Simple Approach To Market Neutral and Get A Strong Hold On Profit With Strangles.)

Double No-Touch
Double no-touch options are the opposite of the double one-touch options. Traders buy them when they expect a range-bound market with a relatively low volatility. In general, this type of option is profitable during the periods of consolidation that usually follow significant market moves. (For more on range-bound trading in the forex market, read Identifying Trending And Range-Bound Currencies.)

Traders often combine various option types to build their option trading strategies. By associating different option types, traders manage to minimize the risk they are taking. Some traders use SPOT options to hedge their portfolios. (For a refresher on hedging techniques, read A Beginner's Guide to Hedging.)

Availability
Individual investors can buy SPOT or binary options through most forex and option trading platforms. Most brokers have their own name for the type of SPOT options they offer; others call them binary options. Options exchanges, such as the CBOE and the NYSE Euronext, make binary or SPOT options available for various products, including indexes. Check the exchanges' websites for availability and trading rules.

Bottom Line
With SPOT or binary options, investors can set their own price and expiration date, giving them complete control over the transaction. The premium quoted by the broker is based on the probability of the scenario being achieved. When the option trader receives the premium quote, they can evaluate the risk-reward tradeoff and decide whether to complete the trade or not. If an investor writes an option and does not like the premium quote, there is no obligation to buy the option. However, once a SPOT option has been purchased, the investor is stuck with it.

SPOT options allow investors to establish a position for less initial capital than would be necessary to create a typical cash position on the market. Investors can use SPOT or binary options to speculate on future market movements before major events, providing another way to hedge their portfolio or speculate on the outcome.