You want to start trading currencies but you heard about forex options trading.
Or maybe not. Perhaps, you’ve been trading the forex spot market like every speculator out there, but you’re curious about this whole options thing.
Either way, we’ll go through the basics of
options in this article. Let’s go.
Forex options trading is all about trading options contracts written on a pair of currencies.
The price of the option contract hinges on several variables and is usually pretty cumbersome to calculate.
That’s why options trading is usually done through complex algorithms.
One of the simpler ways of getting an idea of the option price is using a binomial approach, or what some call binary option trading.
However, we’ll cover that in another article.
Since we’re talking basics:
First, you have to know there are two basic types of options:
1. Call option.
2. Put option.
The Call option (1), let’s you buy an asset in the future at a predetermined price if you want to.
The Put option (2), let’s you sell an asset in the future at a predetermined price if you want to.
In other words, an option contract gives you the option but not the obligation to buy (or sell) something in the future, at an agreed upon price.
Does this sound similar to futures contracts?
Options and futures are similar since in both cases you are buying a contract that allows you to buy or sell an asset (whatever asset is written on the contract) in the future at a price agreed upon today.
The major difference: futures are obligations
while options are…. options.
For example, let’s say you buy an option written on Apple stock.
The option lets you buy Apple stock a year from now at $700 per share.
If a year from now, the stock’s worth $800, you can exercise your option (use it) and buy each share at $700.
In short, you would make $100 from each share bought through the option.
Of course, the option contract wasn’t free. You paid a premium to buy this call option originally.
What happens if price is lower?
Well, if by the end of the year the price is $650, you can just let your option expire, and that’s it.
No need to incur losses.
Option contracts give you flexibility.
Wait. If options are so flexible, why don’t people just trade options instead of futures?
This has to do with your needs.
Just like with any other derivative, there’s a lot of speculative trading.
However, if you’re a multinational manager you might have different needs.
Which takes us to:
Following the example of a manager in a multinational company:
You introduced a new product in Asia, however, since it’s new, you’re unsure about the cashflows it will generate.
But you have foreign exchange risk, so how do you hedge this?
In forex futures trading we covered what a manager might do. If he has an idea of the cashflows, he could buy a futures contract to guarantee an amount of currency at a set exchange rate.
However, in this example, the manager doesn’t know what the cashflows will be (or if there will be any cashflows whatsoever).
For this reason, the manager might want to buy an option contract, so he has the option, but not the obligation to buy (or sell) currency at the specified rate in the future.
What if the manager really needs the future transaction to go through?
Then he is best served by buying a future contract instead of an option.
And this is why both types of contracts exist.
But enough about all that, if you’re a speculator should you start forex options trading?
As was mentioned before, option pricing is more elaborate than spot currency pricing.
Well, some dudes were awarded Nobel Prizes in economics for coming up with a formula to price the options…
Ok…. If you guessed the formula is bothersome…. You’re right!
It requires the use of calculus and a ton of
variables, this is the Black-Scholes formula.
However, this formula is just that, a theoretical model, advanced trading organizations have developed their own variants (or total mutations) to more appropriately model the market.
This is not the only way to price options, but it gives you an idea of the complexities involved.
Also, not all options are created equal, not only can you write them on different types of assets (in our case we care about currencies), but they can have different properties.
For example, an American option can be exercised at any time before expiration, while a European option can only be exercised at the date of expiration.
These are far from the only two types of options as you can probably imagine….
Phew, that makes this an entire world in and of itself.
You can get much more information on the actual currencies because the spot market is wayyy bigger than the options market (think billions vs trillions).
So, besides the fact that there’s less of a focus on the market by part of the media, and that it’s harder to speculate on options profitably, you’ll also have less liquidity than in the spot market.
With those points out of the way, feel free to experiment and check out what you prefer.
Many traders see options as a get rich quick wild card due to their potential profitability, but beware, you will need a much higher degree of sophistication to not lose your shirt.
Much like with trading currency futures, if your goal is to speculate and make some cash, you’re best served with the good old spot currency market instead of forex options trading.
Of course, don’t let me be the last word, check options out by yourself and make your own decision.
This piece was intended to give you a small intro to currency options and what they are.
If you’re interested, come back later since I’ll add more in depth information about forex options trading.
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