As currency trading becomes more popular, so too does currency option trading. Options on currencies have a similar purpose as stock options. The trader who purchases a call option has the right to buy the underlying currency at a specific strike price for a set amount of time. If the price moves higher during that time the call can be exercised. The currency is purchased at the strike price and the trader can turn around and sell it at a higher price in the market. If the currency appears to be trending downward a put can be purchased. This gives the option holder the right to sell the currency at a set strike price for a specific amount of time. If the price falls below the strike price the trader can buy the currency at the lower market price and exercise the option and sell the currency at the higher strike price.
There are two types of contracts used in currency option trading. The first type is the traditional Forex option. With this type the trader can select the strike price and the expiration date. This is different from equity options where stike prices and expirations are preset. After submitting this information to the broker you will find out what the cost(premium) will be. If you accept the premium you select the number of contracts you want and make the purchase. An example would be to buy a call on the EUR/USD pair. You would actually be buying a call on the euro and a put on the dollar. You believe that the euro will rise against the dollar. If this happens and you are “in the money” you can exercise the option and buy the euro and turn around and sell it in the market for a profit. If you are wrong and the dollar rallies against the euro you only lose the premium you paid for the option. If you had instead been long the currency and were wrong in you prediction, the loses would likely have been higher.
The second type of contract used in currency option trading is the SPOT contract. SPOT stands for single payment option trade. As with the traditional option you select the strike price and the expiration date. The broker determines the premium. If you believe the base currency price will rise you buy calls on the currency. If you are correct and the current market price passes the strike price the position is closed and the profit is deposited into your account. If you are wrong you lose the premium.
Premiums are determined using several different factors. The closer the strike price is to the current market price the higher the premium will be. The longer the time until expiration the higher the premium. If the price of the currency being traded is highly volatile the premium will be higher. This is because the volatility gives a better chance for profit.
Currency option trading is done for different reasons. Speculators are strictly profit driven. They use options to simply make money from the currency price movements. They want to “buy low and sell high.”
Hedging is another reason for currency option trading. Those people who may own the underlying currency can use options to hedge their positions against wide and rapid price fluctuations. They may purchase puts with a strike price near the current market price to protect profits they have made with foreign trading partners until they transaction is completed.
Many people buy currency options because their risk is predetermined. They can only lose the amount of the premium. These options can be sold short also. This strategy leaves the trader open to a higher degree of risk though. Your potential for lose is not limited to just the premium you pay. Due to the higher level of risk most brokers will require a substantial deposit to be used as security for this type of trade.
In conclusion, currency option trading can not only limit your exposure to loses but it can multiply your profits if your trades work. Trading options also typically requires less money than trading actual currency contracts.