Understanding Options

Options are usually associated with the stock market, but the foreign exchange market also uses these derivatives in trading. It gives traders the opportunity to make money at a risk he has set for himself. To understand this concept better, let us use the example of purchasing a car.

If you hold a contract that requires you can buy a certain car on May 1st at a price of $1,500, you have an option to buy the car. This option ensures that if the value of the car increases at the predetermined time of purchase (in this case on May 1st), then you will profit from it because you can sell the car to another person for more than the amount you originally paid for.

On the other hand, if the value of the car decreases from the original amount, it wouldn’t be beneficial to buy that car. The option gives you the right to buy, in this case, the car but not the responsibility to pay for it if you don’t want to. This significantly lessens the risks to the trader. There are basically two types of options available to retail traders. These include the traditional call/put option and the single payment option trading (SPOT) trading.

Types of Forex Options

Traditional Option

The traditional call/put option works very much like the stock option. It gives the buyer the right (but not the obligation) to buy from the option seller at a specified time and price. For example, a trader can purchase the option to buy four lots of EUR/USD at 1.4000 for a certain month (this contract is called a EUR call/USD put). Remember that in the options market, you buy a call and a put at the same time. If the price of the EUR/USD goes below 1.4000, then the buyer loses the premium. But if the EUR/USD increases to 1.6000, then the buyer can use the option and gain the four lots for the agreed upon amount and sell it at a profit.

The Forex option are traded over-the counter. Because of this, Forex traders can easily choose the price and date of their preferred option. They will receive a quote regarding the premium they need to pay in order to get the option. There are two kinds of traditional options available today:

American Style Option

Can be used at any point until the expiration date

European Style Option

Can only be used at the point of expiration

Probably the main advantage of traditional call/put option over its counterpart is the fact that it requires lower premium. In addition, because the American-style option allows it to be traded even before expiration, forex traders gain more flexibility. On the downside, traditional options are requires more work to set and execute compared to SPOT options.

Single Payment Options Trading (SPOT)

SPOT options have almost the same concept as traditional options. The main difference is that the forex trader will first give a scenario (UER/USD will break 1.4000 in 2 weeks), gets a premium, and then receive cash if his scenario occurs. SPOT trading converts the option to cash automatically if your trade is successful. This type of option is very easy to trade because it only requires you to enter a scenario and then wait for the results.

Essentially, if your scenario plays out, you receive cash. But if it is incorrect, you will shoulder the loss of the premium. Another advantage of the SPOT option is it allows a wide variety of choices for the trader. He can choose the exact scenario that he thinks will play out. The main downside of the SPOT premium is that it is higher. In general, it costs significantly more than its counterpart.

Benefits and Downsides of SPOT Options

Benefits:

There are a lot of reasons why SPOT options appeal to a lot of investors and forex traders. Among its many benefits include:

• Financial risks is limited to the premium (the payment to buy the option)
• Infinite profit potential
• The trader sets the price and the date
• Requires less money up-front compared to the spot Forex position
• The option can hedge against cash positions and limit risks
• Options give the opportunity to trade on predictions about future market movements without the risk of losing a lot of capital
• SPOT options provide a lot of choices including standard options, one-touch SPOT, No-touch SPOT, Digital SPOT, Double one-touch SPOT, and Double no-touch SPOT.

Downsides:

But if options have all these benefits, why isn’t everyone into this type of forex trading? It is important to recognize that it does have its downsides as well.

• Premium varies depending on the date of the option and strike price. Because of this, the risk/reward ratio fluctuates as well
• SPOT options are not allowed to be traded. Once you buy it, you can’t sell it
• It is difficult to predict when and at what price the market will move

What Determines the Option Price?

As was mentioned earlier, the premium price can vary because of several factors. This is why the risk/reward ratio of forex options trading varies. Some of the factors that determine the price are:

Intrinsic Value

This is the current price of the option if it was used. The position of this price against the strike price can be described in three ways such as “in the money” (when the strike price is higher than the current value), “out of money” (the strike price is lower than the current value), and “at the money” (the strike price and the current value are at the same level).

Time Value