Level 6 Trading - Forex Options
Many people think of the stock market when they think of options. However, the foreign exchange market also offers the opportunity to trade these unique derivatives. Options give retail traders many opportunities to limit risk and increase profit. Here we discuss what options are, how they are used and which strategies you can use to profit.
Types of Forex Options
There are two primary types of options available to retail FOREX traders. The most common is the traditional call/put option, which works much like the respective stock option. The other alternative is "single payment option trading" - or SPOT - which gives traders more flexibility. (Learn to choose the right Forex account in Forex Basics: Setting Up An Account.)
Traditional options allow the buyer the right (but not the obligation) to purchase something from the option seller at a set price and time. For example, a trader might purchase an option to buy two lots of EUR/USD at 1.3000 in one month; such a contract is known as a "EUR call/USD put." (Keep in mind that, in the options market, when you buy a call, you buy a put simultaneously - just as in the cash market.) If the price of EUR/USD is below 1.3000, the option expires worthless, and the buyer loses only the premium. On the other hand, if EUR/USD skyrockets to 1.4000, then the buyer can exercise the option and gain two lots for only 1.3000, which can then be sold for profit.
Since FOREX options are traded over-the-counter (OTC), traders can choose the price and date on which the option is to be valid and then receive a quote stating the premium they must pay to obtain the option.
There are two types of traditional options offered by brokers:
- American-style – This type of option can be exercised at any point up until expiration.
- European-style – This type of option can be exercised only at the time of expiration.
One advantage of traditional options is that they have lower premiums than SPOT options. Also, because (American) traditional options can be bought and sold before expiration, they allow for more flexibility. On the other hand, traditional options are more difficult to set and execute than SPOT options. (For a detailed introduction to options, see Options Basics Tutorial.)
Single Payment Options Trading (SPOT)
Here is how SPOT options work: the trader inputs a scenario (for example, "EUR/USD will break 1.3000 in 12 days"), obtains a premium (option cost) quote, and then receives a payout if the scenario takes place. Essentially, SPOT automatically converts your option to cash when your option trade is successful, giving you a payout.
Many traders enjoy the additional choices (listed below) that SPOT options give traders. Also, SPOT options are easy to trade: it's a matter of entering the scenario and letting it play out. If you are correct, you receive cash into your account. If you are not correct, your loss is your premium. Another advantage is that SPOT options offer a choice of many different scenarios, allowing the trader to choose exactly what he or she thinks is going to happen.
A disadvantage of SPOT options, however, is higher premiums. On average, SPOT option premiums cost more than standard options.
Why Trade Options?
There are several reasons why options in general appeal to many traders:
- Your downside risk is limited to the option premium (the amount you paid to purchase the option).
- You have unlimited profit potential.
- You pay less money up front than for a SPOT (cash) FOREX position.
- You get to set the price and expiration date. (These are not predefined like those of options on futures.)
- Options can be used to hedge against open spot (cash) positions in order to limit risk.
- Without risking a lot of capital, you can use options to trade on predictions of market movements before fundamental events take place (such as economic reports or meetings).
- SPOT options allow you many choices:
- Standard options.
- One-touch SPOT – You receive a payout if the price touches a certain level.
- No-touch SPOT – You receive a payout if the price doesn't touch a certain level.
- Digital SPOT – You receive a payout if the price is above or below a certain level.
- Double one-touch SPOT – You receive a payout if the price touches one of two set levels.
- Double no-touch SPOT – You receive a payout if the price doesn't touch any of the two set levels.
So, why isn't everyone using options? Well, there also are a few downsides to using them:
- The premium varies, according to the strike price and date of the option, so the risk/reward ratio varies.
- SPOT options cannot be traded: once you buy one, you can't change your mind and then sell it.
- It can be hard to predict the exact time period and price at which movements in the market may occur.
- You may be going against the odds. (See the article Do Option Sellers Have A Trading Edge?)
Options have several factors that collectively determine their value:
- Intrinsic value - This is how much the option would be worth if it were to be exercised right now. The position of the current price in relation to the strike price can be described in one of three ways:
- "In the money" - This means the strike price is higher than the current market price.
- "Out of the money" – This means the strike price is lower than the current market price.
- "At the money" – This means the strike price is at the current market price.
- The time value - This represents the uncertainty of the price over time. Generally, the longer the time, the higher premium you pay because the time value is greater.
- Interest rate differential - A change in interest rates affects the relationship between the strike of the option and the current market rate. This effect is often factored into the premium as a function of the time value.
- Volatility - Higher volatility increases the likelihood of the market price hitting the strike price within a limited time period. Volatility is factored into the time value. Typically, more volatile currencies have higher options premiums.
How it Works
Say it's January 2, 2010, and you think that the EUR/USD (euro vs. dollar) pair, which is currently at 1.3000, is headed downward due to positive U.S. numbers; however, there are some major reports coming out soon that could cause significant volatility. You suspect this volatility will occur within the next two months, but you don't want to risk a cash position, so you decide to use options. (Learn the tools that will help you get started in Forex Courses Teach Beginners How To Trade.)
You then go to your broker and put in a request to buy a EUR put/USD call, commonly referred to as a "EUR put option," set at a strike price of 1.2900 and an expiry of March 2, 2010. The broker informs you that this option will cost 10 pips, so you gladly decide to buy.
This order would look something like this:
Buy: EUR put/USD call
Strike price: 1.2900
Expiration: 2 March 2010
Premium: 10 USD pips
Cash (spot) reference: 1.3000
Say the new reports come out and the EUR/USD pair falls to 1.2850 - you decide to exercise your option, and the result gives you 40 USD pips profit (1.2900 – 1.2850 – 0.0010).
Options can be used in a variety of ways, but they are usually used for one of two purposes: (1) to capture profit or (2) to hedge against existing positions.
Profit Motivated Strategies
Options are a good way to profit while keeping the risk down--after all, you can lose no more than the premium! Many FOREX traders like to use options around the times of important reports or events, when the spreads and risk increase in the cash FOREX markets. Other profit-driven FOREX traders simply use options instead of cash because options are cheaper. An options position can make a lot more money than a cash position in the same amount.
Options are a great way to hedge against your existing positions to decrease risk. Some traders even use options instead of or together with stop-loss points. The primary advantage of using options together with stops is that you have an unlimited profit potential if the price continues to move against your position.
Although they can be difficult to use, options represent yet another valuable tool that traders can use to profit or lower risk. Options in FOREX are especially prevalent during important economic reports or events that cause significant volatility (when cash markets have high spreads and uncertainty).