When most people think of options trading, they think of stock options: contracts to buy or sell a given amount of stock for a given price on a given date. But options extend to many other kinds of trades, including foreign currencies. This type of trade is given the shorthand name Forex option trading.
Like any other derivative investment, the contract between the two parties has a value based on changes in price of the underlying asset. Forex option trading lets currency traders create wealth (or lose it) without having to actually purchase the currency pair that is the subject of the contract. Because the actual currency isn’t necessarily held, this type of investment relies on leverage. More leverage means more possibility for gains, but it also means more risk.
In currency option trades where the underlying currency pair is held by the trader, profits can be locked in, and risk minimized. In other words, in order to limit potential losses, the trader has to limit potential gains. With Forex trading, there are two basic types of trades: traditional options and Single Payment Option Trading (SPOT).
To review some of the basic option trading terminology, a call is an option to buy a certain currency in the future at a certain price, and a put is when a buyer acquires the right to sell a certain currency at a mutually agreeable price. With a put option, if the buyer exercises his right to sell the currency, the seller is required to buy the currency at the agreed-upon price. For this consideration, the buyer of the put option pays the seller of the put option a fee known as a premium.
In traditional Forex option trading, the buyer has the right to buy something from the seller at a set time and price, just like with any other type of option trade. But with currency trades, when you buy a call, you are automatically buying a put at the same time. In that, it is like regular currency trading: when you buy one, you simultaneously sell another in the exchange.
Suppose you buy an option for 20,000 Euros at a price of $1.30 each on a date one month in the future. The way this contract is named is Euro call/U.S. Dollar put because you’re buying the option to buy Euros, which you will be trading for U.S. dollars. One of two things can happen.
- If the price of the Euro falls below US $1.30, then you let the option expire, and you are only out the cost of the premium.
- If the price of the Euro rises, say to US $1.40, then you can exercise the right you purchased to buy 20,000 Euros at the old price, US $1.30. Once you have your 20,000 Euros, you can sell them for a profit.
Forex option trading set-ups are further subdivided into two types: American style, where the option can be exercised at any time until the expiration date; and European style, where the option can only be exercised on the expiration date.
Single Payment Options Trading, or SPOT options, are different. The trader proposes a hypothetical scenario, such as: The Euro will go above US $1.30 in ten days’ time. He obtains a premium quote, pays it, and then waits for the situation to play itself out. If the trader is right, he gets a cash payout. If the trader is wrong, he is out the cost of the premium.
While currency option trading is somewhat complicated, it couples increased risk with possible increased profit, and many traders believe the trade-off is worth it for the chance to create wealth quickly.