Understanding Options Trading – Part I

When speaking about forex options, the first thing that usually comes to mind is stock options, and in most cases, the underlying security is indeed a stock. But options contracts can also be applied to other financial instruments such as commodities, indices and even currencies. Options have in fact become an alternative investment of choice for many investors and traders, corporate or individuals, seeking to hedge their funds or simply increase their profit. As far as hedging is concerned, currency options are generally used by export and import companies wishing to secure a certain exchange rate at a futuredate. As for speculators, they use options, various option combinations and options strategies to take advantage not only of market moves in a volatile market but also of stable rates in range-bound markets. Through its options trading platform, Finotec offers forex options on majors and other pairs. Option trading at Finotec is very simple: once you have accessed the platform, click "option" at the bottom of the streaming quote of your choice and place your order. Depending on the option type you choose "vanilla or exotic" the input required varies. For regular call and put options, you need to fill in the amount, strike and expiry fields.

To understand what options are, think of them as a type of insurance policy: they are effective and valid only if certain conditions are met.

Forex Option Trading Definition

A forex option is a contract between a buyer and a seller under which the buyer has the right - but no the obligation to sell (or buy) a specific amount of one currency against another at a predetermined price and on or before a preset date in the future. In return for this right, the forex option buyer will have to pay a one-time sum, called "premium" to the seller.

The Rights and Obligations of Buyer and Seller

The party buying the currency options contract (also known as buyer or "holder") may choose to either sell it before the expiration date or keep it until the expiration date (in which case in expires worthless). If the buyer decides to sell the contract before expiry, he/she exercises his/her right to take a position in the underlying spot market. On our options trading platform, as soon as the buyer exercises his right (to buy or sell the currency), his position is liquidated for immediate payout. If the market has moved in his favor, then he takes in the difference between the market price and the strike price. If the market has moved against him, the position is just closed he has already paid and lost the premium.

The buyer's only financial obligation is thus the premium he must pay to the seller. On the expiration date, a call buyer may exercise his/her right to buy the underlying spot position at the strike price, while a put buyer may exercise his/her right to sell the underlying spot position at the strike price. However, buyers often sell the currency options contract before the expiration date. In options trading, there is no limit to the possible profit of the buyer.

If the buyer exercises his right, the party selling the currency options contract (also known as seller or writer) is obligated to take the opposite underlying exchange rate spot position. The idea is that the premium paid by the buyer will cover the risk in case the seller is forced to take an adverse position on the underlying spot market.

When trading options, there must be enough money in the forex option seller's account to cover the initial margin requirement. If the market moves against the seller, he/she might be required to add funds to his account to keep the balance above the margin requirement. The most profit the writer (seller) can make is the value of the premium received from the buyer. On the other hand, there is no limit to his possible loss.

Strike Price

The set rate at which the buyer (or holder) may exercise the option to buy (for a call) or sell (for a put) the underlying currency when exercising the option contract. Upon exercising the option, the buyer will make profit (in the case of a call) if the strike price exceeds the spot rate by enough points to cover the price of the premium, and if the strike price falls behind the spot rate by enough points to cover the price of the premium (in the case of a put option). Usually, the higher the difference between the spot and the strike price, the lower the price of the option (premium) since it has less chance of hitting the strike price.

Forms and Types of Forex Options

In forex trading as in stocks trading, there are two basic forms of options: the call and the put option.

• A call option gives the holder (buyer) the right to purchase a certain amount of the underlying currency at a specified price (the strike price) and date.
• A put option gives the holder the right to sell a certain amount of the underlying currency at the strike price.

Forex options are divided into two major categories, both available on the Finotec Trading Platform: vanilla and exotic options. The major difference between those categories lies in the variables that they integrate. Each category contains several Options Types:

• Vanilla options: these are the simplest types of options. The origin of the name is not clear. They refer to standard CALL and PUT forex options contracts. Please note that "put" and "call" forex options contracts are note the opposite of the same transaction but two separate transactions. This means that for every forex call option buyer there is a call seller and for every forex put option buyer there is a put seller. Under our platform's Vanilla options, you will also find both straddle and strangle options strategies. These last options types are actually defined as options strategies.
• Exotic options: Unlike plain vanilla options with single strike prices and standard expiration dates, exotic options are based on more complex conditional time and price scenarios. Exotic options include different types if options including "barrier" options (knock-in, knock-out, reverse knock-in, reverse knock out) and "binary" options (one-touch, no-touch, double one touch, double no touch).

In general, options can be either American-style or European-style. American-style options may be exercised at any point until the expiration date. European-style options may only be exercised at the time of the expiration date.

Options trading with Finotec is facilitated by a complete set of tools designed to help traders make considered trading decisions.

Continue to Options Trading - Part II

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