As currency trading becomes more popular, so too does currency options trading. Options on currencies work in many ways like equity options or options on futures. If a trader believes that a currency’s price will rise, he/she buys a call on the currency. This gives them the right to call(buy) the currency away at a set price for a specified period of time. On the other hand if he/she believes that a currency’s price will decline soon they can purchase a put. This allows the trader to put(sell) the currency at a specific price for a specified period of time. It should be noted that these are rights and not obligations.
Currencies trade in pairs. The base currency(first one in the pair) is the one that has the call or put being purchased on it. One type of option contract is the traditional option. Unlike equity options the trader can select the strike price and expiration date. The broker will then decide on the premium they will charge to enter into the contract. If the trader feels the premium is acceptable, he/she decides on the number of contracts and enters the order with the broker.If the trader believes that the price of the pound will rise against the dollar they will buy calls on the GBP/USD. If this actually happens before the option expiration date, the trader will exercise the option and purchase the pound. He/she will then be able to turn around and sell the pound at the then higher price, making a profit. If this scenario does happen the option is said to be “in the money.” If the pound actually drops against the dollar, the option will expire worthless. The only loss to the trader will be the premium paid for the right. The risk on this type of transaction is really quite a bit lower than it is on outright trading of the currency itself. Trading currencies does not limit the traders exposure to losses like options do. This is a major advantage to trading them.
Another type of currency option is the SPOT contract. This option more closely resembles equity options. It does not have to be exercised in order to realize a profit. SPOT stands for single premium option trade. If you think a currency price will rise from current levels you select the strike price(exercise price), select the expiration date and purchase the contracts you want. If you are correct and the price moves higher before the expiration date, the profit is simply credited to your trading account. Premiums on SPOT contracts are usually higher than those on traditional options.
Premiums on options are determined using a number of factors. The most common factors are the time between now and the expiration date. The longer the time period the higher the premium. The closer the strike price is to the current market price the higher the premium will be. The volatility of the currency price will also typically affect the premium level.
The are several reasons traders participate in currency options trading. For the speculator the reason is purely for profits. Due to the limited risk, it can be a much easier way to profit from moves up and down in a very accessible market. Trading in currency options can be done 24 hours a day, 5 days a week just like the underlying currency.
Currency options trading is a strategy used by many who are attempting to hedge actual positions they are currently holding in the currency. If they are long the currency, they may buy puts to hedge themselves from a decline in price. If they need to make payments using the currency in the near future, they can buy calls to protect themselves from a rise in prices.
Thus far we have discussed buying calls and puts. This is the most common way to trade options. There are those you sell options on currencies though. If you feel that a currency price will remain steady or within a small range for a period of time, you may sell puts or calls. If the price remains steady the option will expire and you can keep the premium. Due to the higher level of risk the trader is exposed to with this style of trading, larger amounts of money are required to be on deposit.
Currency options trading can be extremely profitable if done correctly. The lower cost of participating makes it easier for more people to get involved. The limited amount of capital at risk is also very appealing.