Introduction to SPOT Options

By Hans Wagner AAA

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 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 SPOT 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 his/her 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 on 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 outside the U.S., 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.

SPOT options are vanilla put and call options whose value is set by the conditional scenario, not just the price and the expiration date.

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

  • While a bit different from normal options, SPOT 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 SPOT options, this is never a problem, since there is never a need to close out the position - it is a one-sided trade.
  • SPOT options give you the opportunity to create different scenarios that allow choosing exactly what you believe will happen in the market. In fact, investors who use SPOT options define the specifics of the trade.
  • With SPOT options, the downside risk is limited to the premium paid.
  • The option scenario defines the reward, so it is known before entering the trade. Before committing to the trade, you know the risk-reward tradeoff.

SPOT options also have their disadvantages:

  • Once you have bought a SPOT 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 only accept or reject the premium payment.
  • 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 your goal for the trade. Fortunately, different types of SPOT options help 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 SPOT option is the "up/down," where you believe an underlying security will 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 two weeks.

No-Touch
When buying this type of option, you set the amount of profit that you 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 one week would be the way to go.

Double One-Touch
With a double one-touch option, you choose two price points and set the profit you 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.

Double No-Touch
Double no-touch options are the opposite of the double one-touch options. You buy them when you expect a range-bound market with a relatively low volatility. In general, this option type is profitable during consolidation periods that usually follow significant market moves.

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.

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 outside the U.S. call them binary options.

The 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, he/she can evaluate the risk-reward tradeoff and decide whether to complete the trade. 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.

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