Forex Options Trading
When speaking about options trading, people usually think of stock options. However, options can also be applied to other financial instruments such as commodities, bonds, or even currencies. Options have in fact become an alternative investment of choice for many investors and traders, corporate or individuals, for hedging their funds. When used in Forex Trading online forex trading, options allow traders to increase their gain and limit their risk. In fact they allow the Finotec is one of the few online forex brokerage firms to offer options on the main currency pairs.
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 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.
Back to topThe 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 its expiration date or keep it until its expiration date. In this case, the buyer exercises his/her right to take a position in the underlying spot exchange rate. On an online trading platform, as soon as the buyer takes this position, the position is automatically closed for immediate payout. If the market moved in his favor, then he takes in the difference between the market price and the strike price. If the market moved against him, the position is just closed – he has already paid 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. 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.
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. There is no limit to his possible loss.
There are two main Options Types,and Finotec offers both of them:
- Vanilla options: these are the simplest types of options and usually refer to standard CALL and PUT forex options contract. 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. Vanilla options also include straddle and strangle options, which actually can be considered more 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 “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).
All those 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.
Back to topStrike price
The set rate at which the buyer (or holder) may buy (for a call) or sell (for a put) the currency when exercising the option contract. He strike price can be set either “out of the money,” “in the money,” or “at the money.” The more an option is inside the money, the more expensive it is or the higher the premium.
Back to topOut of the money/ in the money / at the money
These terms are used to describe the position of the current underlying market rate with regards to the strike price. This also refers to the intrinsic value of a forex option, more precisely: the difference between the strike price and the underlying spot rate.
When an options contract is “out of the money”, it means that underlying currency spot rate is lower than the strike price (in the case of a call option), or higher than the strike price (in the case of a put option). When this happens, the forex options contract expires worthless.
Back to topIn the money
- CALL: When current market price is > than the strike price
- PUT: When current market price is < than the strike price
Out of the money
- CALL: When current market price is < than the strike price
- PUT: When current market price is > than the strike price
At the money
- CALL & PUT: When current market price is = than the strike price
Using options
Hedging
- PRICE = intrinsic value+time value
- Intrinsic value is the advantage to the holder of the option of the strike rate over the forward outright rite
- Time value is a mathematical function of implied volatility time to maturity interest rates differentials, spot and the strike of the option
- Volatility
- It is a statistical function of the movement of exchange rate it measures the speed of movement within an exchange rate band