By agreed definition, forex options trading are a contract between two parties, a buyer and a seller, in which the buyer possess the right to buy or sell, but not the legal obligation, a certain amount of a particular currency against another specified currency at a fixed price called the ‘strike price’ on or before the expiry of the option contract. For this privilege, the buyer of the option will pay the seller a one-time lump sum called the ‘premium’.
The Type of Forex Options
Essentially, there are two types of forex options trading, the ‘put’ option and the ‘call’ option. A ‘call’ option permits the buyer to buy a specified amount of the underlying currency at the strike price. A ‘put’ on the other hand, permits the buyer to sell a specified amount of the underlying currency at the strike price. Options can further be categorized as ‘vanilla options’ or ‘exotic options’. Vanilla options are just standard options with a single expiry date and strike price. Exotic options on the other hand, have several additional variables integrated into them. Their status can be set to pertain to certain holding times or price scenarios. Examples of exotic options are ‘barrier options’ and ‘digital options’.
The attractiveness of trading in options lies in their versatility. They allow an investor to adjust their market position to any circumstances that arises. They allow the investor to take a speculative stand in his trading by using options as an investment vehicle or if he chooses to take a conservative stand in his investment by using options as a risk management tool. Nevertheless, this versatility is not without its opportunity cost in the sense that trading in options can be speculative and involves substantial risks.
Making a Trade- Example
The way an investor makes money from trading in forex options is through the differences between the strike price and the spot price. If the market is in the investor favour, then the difference between the market price and strike price will represent his profit. For example, upon the expiration date, a ‘put’ buyer may exercise the right to sell the underlying currency of the option at the strike price, say $2, which is happened to be higher than the spot price, say $1.50. Therefore, the $0.50 will represent the profit of the investor trading in the ‘put’ option.
As mentioned earlier, forex options trading involves substantial risks and traders must only trade in options with ‘risk capital’, that is money which they can afford to lose without impacting their financial health. The risk of trading in options becomes even higher when the trader is inexperienced. As such, if you are new to forex option trading, it is highly advisable that you educate yourself first in this market before you start trading in forex options.