Trade Forex Options

Posted by admin 11/11/2013 Comments are off 941 views

This article is about the reasons for trading forex options.

Forex Options

Most people immediately think of the stock market when you mention options.  The forex market also offers traders the opportunity to trade these derivatives.  Options give you the chance to limit your risks and increase your profit.

Types of Options

There are two main types of options available to foreign exchange traders.  The most commonly used one is the traditional call and put option.  This operates very much like the stock option.  The second one is the single payment option trading or spot which offers much more flexibility.

Traditional Options

Traditional options give the purchaser the right, not the obligation, to buy from the seller at a predetermined price and time.  For example, a trader may decide to buy an option for the purchase of two EUR/USD lots at 1.2000 in a month’s time.  This contract is referred to as a EUR call/USD put.  You should bear in mind that in the options market, when you purchase a call, you purchase a put at the same time – much the same as in the cash market.  If the price of the currency pair goes below 1.2000, the option will reach its expiry date as worthless.  The purchaser will lose the premium on this contract.  If the currency pair went up to 1.3000, the purchaser can exercise its option and will gain the two lots at the lower price of 1.2000.

As the forex options transactions are carried out over the counter, traders have the choice of price and date and receive a quote which states the premium they have to pay to obtain that option.  Brokers offer two types of options.  The American option can be activated at any point until the expiration date.  The European traditional option is only available at the expiration date.

The one advantage linked to options is that the premiums are lower than those of spot options.  The American traditional option is able to be bought and sold prior to expiration which allows more flexibility.  The disadvantage is that traditional options are more difficult to enter and execute than spot options.

Spot Options

The way options works in this market is that a trader sets a scenario that let’s say, the EUR/USD will go beyond 1.2000 in 14 days.  The trader obtains an option cost quote.  If the scenario plays out in that time, the trader receives a payout.  Spot automatically converts options to cash if you enter a successful trade.

Why Trade Forex Options?

There are several reasons why options appeal to so many traders.

  • The profit potential is huge
  • The downside risk to the option premium which is the amount you had to pay for the purchase of the option is limited
  • The amount payable up front is less that for a normal forex position
  • You can make use of options to hedge against spot positions in a bid to limit your risk level
  • It is possible to make use of options to trade on market movement predictions before major fundamental events occur

So, you ask yourself, why do we not all trade options?  As usual, there are the pitfalls to think of.

  • The strike price and the option date can cause the premium to vary which means the risk to reward ratio varies
  • You cannot change your mind about options

 

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