Currency options trading have been known for by forex retail traders worldwide. You can learn more about it in this article.
Most people normally think of the stock market when hearing the word options. But there are also other markets that offer the opportunity to trade these derivatives. For instance, the foreign exchange market offers traders the opportunity to practice currency options trading.
Foreign exchange traders decide to use options in order to gain profit or protect against any potential losses. Initially, the forex options trading are conducted only by the large institutions. But that is no longer the case in this day and age.
In this article you will learn more about what currency options actually are, as well as the three types of currency options every currency option trader should learn about.
What is a Currency Option?
A currency option is a type of contract or a derivative financial instrument. With it, the buyer is given the right to buy or sell the specified currency at a predetermined exchange rate on or before a specific date. However, it does not come as an obligation to the buyer.
This right doesn’t come for free either. A premium is normally paid to the seller in order to own such right. The amount of this premium may vary depending on some factors. There are two main factors that you should consider. One is the number of contracts if the option is bought on an exchange. Second is the number of contracts if the option is bought on the nominal amount of the option if it’s done on the Over the Counter or OTC market.
The currency option is also considered as one of the most common ways for hedging. This strategy is normally used by corporations, individuals, or financial institutions. It can be effective for hedging against adverse movements in the exchange rates.
Investors can take advantage of currency options when it comes to hedging against potential foreign currency risk. You can either buy a currency put or currency call. These are the two main types of options: calls and puts.
Options are still considered as one of the hedging strategies available to the businesses. Most people still practice using options as an instrument for speculations.
Components of Currency Options
There are also various components that affect how the options are priced. Here are some of those components.
The premium is the price that you, as the option buyer, are set to pay. After paying such, you will gain the right to buy or sell the currency at a fixed rate on or before a set maturity date.
This is the rate at which you, as the owner of the option, will be able to manage the currency. It’s the exchange rate at which the currency will be bought or sold before it reaches its maturity date. If your position has been held for a long period in call, this will show the rate you will be able to buy the currency. On the other hand, positions held long a put will show the rate at which you can sell the currency.
This is also known as the expiration date of the option. In relation to the strike price, its most commonly compared to the then-current spot rate. In case the option expires in the money, the currency option is cash settled. However, if the option expires out of the money, the currency option will expire worthless.
Type of Option
The type of option can also affect the currency option. In relation to the strike, the option can be exercised or might expire worthless.
Where the spot rate is being exchanged is also an important component. Much like the type, the option can be exercised or might expire worthless when it comes to the strike price.
Currency Options Trading: Types of Currency Options
There are existing three types of options primarily available to retail forex traders when it comes to currency options trading.
Additionally, two of these types of options that are already considered as traditional ones. They are also considered as the main types of currency options and are known as the call and put options.
A call option is one of the two main types of currency options. Call options provides you with the right to purchase an underlying asset. As was mentioned before, it does not require you to make a purchase. You still have the choice not to buy the asset if you wish.
The purchase must meet the specified price or the strike price, and must be made at the predetermined date. If the stock ends up not meeting the striker price before the maturity date, the option will then expire and become worthless.
Calls are usually bought during times when investors expect the share price of the underlying asset will rise. Meanwhile, calls are sold when speculations end up having negative results. The act of selling an option is also referred to as “writing” an option.
Having a put option will give you the right to sell an underlying asset at the specific price or strike price. It’s also known as another of the main types of currency options.
The seller, also known as the writer, of the put options needs to buy the stock at the strike price. You can use the put option any time before the option expires.
The put options are normally bought during times when speculations regarding the share price of the underlying asset are negative. They are usually sold when investors expect the share price to rise.
Put buyers are characterized by their decisions to hold “long” positions. They are generally categorized into two. One is the speculative buyers who are searching for leverage. The second ones are the “insurance” buyers who are aiming for the protection of their long positions in a stock. These positions are normally held for the period of time that the option covers.
Put sellers are known to be the ones who decide to hold “short” positions. This is the result of expectations that the market will move upward or, at the very least, remain stable. A downward market turn can spell trouble for put sellers.
The maximum profit you receive is limited to the received put premium. This is gained once the price of the underlying is greater or equal to the option’s strike price upon expiration. Maximum losses on the other hand may be unlimited if you are an uncovered put writer.
Single Payment Options Trading (SPOT Options)
The single payment options trading or SPOT option is the third type of currency option available to retail forex traders. SPOT options are known in the field of currency options trading for having higher premium cost when compared to the traditional options. Regardless, they are also known for being easier to set and execute.
When it comes to buying a SPOT option, a currency trader must first input a desired scenario. After that you can wait for the premium to be quoted. If a buyer decides to buy this option, there are automatic settings that will be triggered when a certain circumstance is met. For instance, the payout is automatically given by the SPOT in case the specified scenario occurs. The option is essentially converted to cash automatically.
So basically, the single payment options trading work in this sequence. The trader inputs a scenario, obtains a premium quote, and then receives a payout in case the scenario actually takes place. Successful option trades in SPOT will result to automatic payouts, converting the option to cash.
SPOT options are easy to trade in the sense that it is only a matter of entering the scenario and letting it all play out. If you are correct, you will receive cash directly into your account. In case you were wrong, your loss will be your premium.
One other advantage that single payment options trading offer is the choice of many different scenarios. This will allow the trader to choose exactly what he or she expects to occur. However, one disadvantage of the SPOT options is the higher premiums. SPOT option premiums generally cost more than the standard options.
There are various factors that can become the deciding factor when it comes to making a decision on whether you should or should not participate in currency options trading. You should also consider its pros and cons; weigh your options carefully before making any final decisions.
You should also read up on your investments before placing your own money out in the field. You should not be afraid to make mistakes since you are still bound to learn from them.
Keep in mind that when it comes to hedging, currency options trading can play a vital role. They can be used to hedge against any potential losses you may incur while trading.
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