Forex options trading works very similar to how it works in the stock market. You buy an option call or put from a seller with a set price and expiration date. Let’s start with some basic trading terms.
Writer – The person who writes the options contract has to make delivery if it is executed.
Seller – The writer must be the initial seller of the contract, but they are not one in the same. The second holder of the contract can resell it making him the seller.
Buyer/Holder – The person who is given the right to buy a specified number of lots of the currency for a specified price.
Premium – The fee that the buyer pays for the contract.
Strike Price – The price at which the option holder has the right to buy the currency.
In the Money – When the strike price is met or exceeded.
Out of the Money – When the strike price is not met.
In the forex market you might buy option contract for USD/CAD at 1.05 to expire in 30 days. If the USD/CAD breaks to 1.07, then you would exercise the contract to buy at 1.05. You would then sell for 1.07 for a nice profit. If it doesn’t break out of 1.05 by the expiry date, than the only thing you lose is the premium.
Speculation and Hedging Risk
Some traders use currency option trading as their primary mode of speculating and some use it to hedge against risk. By speculating I mean they are purely trying to make profit from this. Some of course use it to hedge there risk. In fact, there are people out there that say that’s the only way it should be used.
Speculators can take advantage of the fact that it takes less cash to do an option. In addition, in terms of losses, you limit the risks to just your premium. You basically establish upfront what you are willing to lose. With the regular forex cash position, you are generally trading on a forex margin account. This involves putting a lot of money down on deposit.
In addition, trading on margin puts a lot more cash at risk. With forex option trading, you limit your losses merely to your premium. And your premium is something that you can negotiate.
There are a few downsides to currency options trading. First of all, there is an expiry date. That means if your timing predictions don’t pan out, you lose your premium. You can’t wait it out like if you had an open cash position.
Another downside is that you can’t trade it once you buy it. It’s yours until the expiry date hits, whether for good or bad. That means if the market makes an unusual move, you will be out of luck in terms of trying to unload your option contract.
For hedgers, trading forex options can be used to hedge the risk of a regular open position. This takes a bit of calculation. If you enter an open cash position on EUR/USD, you can set an option position opposite of that. This way, you winner either way. But again, if you don’t do it right, you might lose money either way as well.
Hedging can get very complicated. You have to price the option contract properly and make sure it protects against a losing open trading position. It can get a little tricky.
Forex options are bought and sold over the counter (OTC), which means the terms are flexible. The price and the expiration date is fluid. The premium, which is the cost of buying an option, is also fluid.
Whatever forex trading strategies you use, you can utilize options as a complement or to replace an open trading position. It is a little more complex than your straightforward trading, but it can be a very effective and low-risk way to trade.