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What Are Forex Options
In finance, forex options, referred to also as currency options or FX options, are derivative financial instruments that give their owner the right and not the obligation to exchange money in one currency into another at a rate agreed upon on a specific date. The currency options market is the largest, deepest and most liquid market when compared with options of any other kind. Forex trading is mostly conducted over-the-counter and is regulated lightly. However, a fraction of the trading happens on exchanges such as the International Securities Exchange, the Chicago Mercantile Exchange or Philadelphia Stock Exchange on futures contracts for options. Options provide retail traders several opportunities to increase profit by limiting risk.
There are two types of forex options that are available to retail traders. The common type is the traditional call or put option, similar to the stock option. The second type is the single payment option trading referred to as SPOT option which enables more flexibility to traders.
Traditional Forex Options
Traditional options provide the right, but not the obligation, to buy anything from the seller of the option at the pre-set price as well as time. For example, a trader may buy an option on two lots of EUR/USD at a price of 1.3000 in a month. Such a contract is referred to as a EUR call/USD put. This is because in the options market a trader who buys a call also buys a put simultaneously. By the expiry time, if EUR/USD trades below 1.3000, the option becomes worthless and the trader loses the premium. If EUR/USD zooms to 1.4000, the trader can exercise the option to gain two lots for 1.3000. The trader can then sell the two lots and earn profit.
In forex options, traders can select the price as well as the date on which the option should be valid and then get the quote that specifies the premium they have to pay in order to obtain the option. Brokers offer two types of traditional options: American style and European style. Whereas the American style option can be exercised any time till expiration, the European style option can be exercised only at expiration time. A major advantage that traditional options offer is lower premiums when compared with SPOT options. Moreover, American style traditional options offer greater flexibility. However, it is difficult to set as well as execute traditional options than SPOT options.
SPOT Forex Options
The working of the SPOT option is best explained with an example. If a trader believes that EUR/USD will breach 1.3000 in two weeks, he/she will have to obtain a quote to determine the option cost. In the event of EUR/USD breaching the price barrier by the specified time, the trader receives a payout. In fact, the option is automatically converted to cash in the case of a successful trade and payout is made.
SPOT options are easy to trade and provide many choices to traders. All the trader has to do is to enter a scenario. If the trader’s prediction turns to be correct, he/she receives cash into the account. If the prediction turns out to be incorrect, the trader loses the premium. However, a disadvantage of SPOT options is the higher premium or cost of the option.
Corporations generally make use of forex options as a hedge against uncertain foreign currency future cash flows. The thumb rule is: hedge certain cash flows in foreign currency with forwards contracts and uncertain cash flows in foreign currency with options.
For example, imagine that a manufacturing firm in the United Kingdom is expecting a payment of USD 100,000 for engineering equipment which is to be delivered in three months. During the period, if the GBP becomes stronger against the USD, the manufacturing firm in the UK stands to lose as it will only receive less GBP when it converts USD 100,000. On the other hand, if the GBP becomes weaker against the dollar, the UK manufacturing firm gains because of the more GBP that it receives on conversion. Such an uncertainty exposes the firm to forex risk.
Considering the fact that the cash flow is certain, the UK firm might enter into a forward contract for delivering USD 100,000 in three months in exchange for GBP at the prevailing forward rate. This forward contract exactly matches the exposure of the firm and hedges its forex risk.
On the other hand, if the cash flow is uncertain, a forex options contract would be a better choice. The UK firm might buy a GBP call/USD put option in order to protect the GBP value that the firm expects in the three months period if cash is received or yield a profit if the cash is not received, but the forex rates are in its favor. The cost that the firm incurs will at the most be the option premium, unlike a forward contract wherein losses can be unlimited.
Benefits of Trading Forex Options
Forex options are appealing to many traders because of many reasons and some of them are as given below:
• The downside risk is restricted to the option premium.
• The profit potential is unlimited.
• The trader pays only less money when compared with cash forex position.
• The trader can set the expiration date as well as the price.
• Options can be made use of to hedge open cash positions so as to manage risk.
• The trader can use options contracts to trade market movements prior to release of economic data or other news release without risking too much capital.
• SPOT options provide several choices to traders such as standard, one-touch, no-touch, digital, double one-touch and double no-touch options.
Though traders need to develop required skill and understanding of the currency market’s behavior in order to trade forex options, it does present a valuable opportunity to lower risk and maximize profits. Opportunities for trading in forex options become available, especially during the time of release of important economic reports or events that cause significant volatility in the market.