What Is Forex Options Trading?
Forex options are derivatives based on underlying currency pairs. Trading forex options involves a wide variety of strategies available for use in forex markets, where foreign currencies are traded. The strategy a trader may employ depends largely on the kind of option they choose and the broker or platform through which it is offered.
The characteristics of currency options trading include a decentralized forex market that varies much more widely than options in the more centralized exchanges of stock and futures markets.
- Forex options trade with no obligation to deliver a physical asset.
- These options vary widely from one product to another depending on which entity is offering the option.
- Forex options come in two varieties, so-called vanilla options and SPOT options.
- SPOT options are binary in nature and pay out (or not) depending on the final condition of the option.
Understanding Forex Options Trading
Options traded in the forex marketplace differ from those in other markets in that they allow traders to trade without taking actual delivery of the asset. Forex options trade over-the-counter (OTC), and traders can choose prices and expiration dates which suit their hedging or profit strategy needs. Unlike futures, where the trader must fulfill the terms of the contract, options traders do not have that obligation at expiration.
Traders like to use forex options trading for several reasons. They have a limit to their downside risk and may lose only the premium they paid to buy the options, but they have unlimited upside potential. Some traders will use FX options trading to hedge open positions they may hold in the forex cash market. As opposed to a futures market, the cash market (also called the physical and spot market) has the immediate settlement of transactions involving commodities and securities. Traders also like forex options trading because it gives them a chance to trade and profit on the prediction of the market's direction based on economic, political, or other news.
However, the premium charged on forex options trading contracts can be quite high. The premium depends on the strike price and expiration date. Also, once you buy an option contract, it cannot be re-traded or sold. Forex options trading is complex and has many moving parts, making it difficult to determine their value. Risks include interest rate differentials (IRD), market volatility, the time horizon for expiration, and the current price of the currency pair.
Forex options trading is a strategy that gives currency traders the ability to realize some of the payoffs and excitement of trading without having to go through the process of buying a currency pair.
Primary Types of Forex Options Trading
There are two types of options primarily available to retail forex traders for currency options trading. Both kinds of trades involve short-term trades of a currency pair with a focus on the future interest rates of the pair.
- The traditional ("vanilla") call or put option. With a traditional, or vanilla, options contract the trader has the right—but is not obligated—to buy or sell any particular currency at the agreed-upon price and execution date. The trade will still involve being long one currency and short another currency pair. In essence, the buyer will state how much they would like to buy, the price they want to buy at, and the date for expiration. A seller will then respond with a quoted premium for the trade. Traditional options may have American- or European-style expirations. Both the put and call options give traders a right, but there is no obligation. If the current exchange rate puts the options out of the money (OTM), they will expire worthlessly.
- A single payment option trading (SPOT) product. A SPOT option has a more flexible contract structure than a traditional option. This strategy is an all-or-nothing type of trade, and they are also known as binary or digital options. The buyer will offer a scenario, such as "EUR/USD will break 1.3000 in 12 days." They will receive premium quotes representing a payout based on the probability of the event taking place. If this event takes place, the buyer gets a profit. If it does not occur, the buyer will lose the premium they paid. SPOT contracts require a higher premium than traditional options contracts do. Also, SPOT contracts may be written to pay out if they reach a specific point, several specific points, or if they don't reach a particular point at all. Of course, premium requirements will be higher with specialized options structures.
Not all retail forex brokers provide the opportunity for options trading, so retail forex traders should research any broker they intend to use to ensure they offer this opportunity. Due to the risk of loss associated with writing options, most retail forex brokers do not allow traders to sell options contracts without high levels of capital for protection.
Example of Forex Options Trading
Let's say an investor is bullish on the euro and believes it will increase against the U.S. dollar. The investor purchases a currency call option on the euro with a strike price of $115, since currency prices are quoted as 100 times the exchange rate. When the investor purchases the contract, the spot rate of the euro is equivalent to $110.
Assume the euro's spot price at the expiration date is $118. Consequently, the currency option is said to have expired in the money. Therefore, the investor's profit is $300, or (100 * ($118 - $115)), less the premium paid for the currency call option.