Currency Options Trading – Everything You Wanted to Know
In the course of their activity banks and participants of foreign economic relations actively use trading in currency options (FX-options). FX options help to reduce currency risks as they allow you to exercise your right to buy/sell currency at a predetermined exchange rate.
What are the Currency Options?
A currency option is a forward contract between the seller and the buyer, the future owner of the option contract. According to the existing rules, the buyer of an option gets the right to buy or sell a certain amount of currency. On a fixed date, the basic asset in question may be exchanged for another currency at a rate fixed at the time of entering into the contract - the option exercise price.
Currently, a huge number of such types of contracts are being executed in the market. In fact, their number is limited by the number of national currencies traded on the exchange. For instance, a currency option may provide for the exchange of the British pound into the Japanese yen, the euro into the Swiss franc, the Australian dollar into the euro and so on. An investor should understand the difference between the base currency and the trading currency. If a trader mixes up these concepts, he may incur large losses because of such a ridiculous mistake. The trading currency is the monetary unit, employing which the price of an option contract execution is expressed. Basis currency is the currency that will be sold or bought by the option holder at the moment of contract expiry.
All currency options contracts have a certain set of essential conditions. These include:
the amount of the asset to be traded;
option exercise period.
The trader needs to understand that currency option contracts have strict conditions. Once they are entered into, the important terms described above are not subject to change. Investors can use currency options for various speculations. At the same time, risk hedging is the most popular strategy for their application in practice.
Uses for Currency Options
A call option is used when the market has an upward trend in the quotes of the base currency or when it is necessary to hedge a short position. And vice versa. The Put option is designed to provide long position insurance or earnings to the trader if there is a descending trend.
Many investors practice the following strategy. They have in their hands at the same time futures for growth of quotes of a particular currency and an options contract for its sale. Thus, they insure themselves against possible market fluctuations.
In this situation, when the quotes on the underlying asset grow, the trader gets the profit from the futures, but losses from the option. The size of the latter is equal to the cost of purchasing an option contract. Therefore, the total investor profit will be equal to the difference between the profit from the futures and the option reward.
European and American styles of options
American-style options differ in that the owner can execute his right to buy/sell the underlying asset at any time without waiting for the closing date. Since an American option gives more rights than a European one, the cost of an American option can never be lower than a European option. This does not mean that an American option should require more.
If an American call option that is in-the-money is exercised in advance, then the option holder will only be able to exercise the intrinsic value calculated as the difference between the spot price of the underlying and the strike price. However, the same call option can be sold on an exchange at the market price, which includes both the internal and the time value. Early execution will simply result in the loss of the time component. And because the stock does not pay dividends, the investor will not lose profit from the option exercise to receive the dividend. Since it makes no reasonable sense to execute an American option before the expiration date, the price of the American option should be equal to that of a European option.
On the other hand, sometimes the exercise of an s in-the-money American put option before the exercise date makes sense even if the stock does not pay dividends. For example, a trader holds a put option with an expiration date in one year and a strike of $110. The value of the basic asset is almost zero and its volatility is very low. Since the price of the asset cannot be negative, the profit potential is almost depleted and the funds received from the early exercise of the option can be reinvested at the risk-free interest rate right now. Thus, the interest earned can sometimes exceed the potential profit from a share fall to zero. In such cases, the option may have a negative time value.
Should I trade options or Forex?
Options trading can present some definite benefits for today’s active trader. The marketplace is highly regulated, meaning that a defined system and concrete marketplace help to quell any uncertainty about the person on the other end of a trade. Profits can also be made in most market conditions – up, down, and sideways. A centralized price also helps to keep things consistent. However, options can only be traded from Monday to Friday, during “standard” work hours – 9:30 am – 4:00 pm EST. This means that the savvy investor sits around and watches his or her investment do nothing. Forex trading, on the other hand, enables a trader to start an account and begin making financial moves with very little upfront money. Easy diversification is also possible when traders utilize micro or mini lots of currency and keep leverage ratios within reason. Markets are open 24 hours a day during the working week, and trades are even possible on weekends – though most trading groups don’t support this, and the ones that do often charge large premiums for the service. Keep in mind, however, that Forex isn’t as regulated as a traditional stock exchange (many traders see this as an advantage), and your broker takes the other side of your trade when dealing with currency exchanges. When deciding which option is best for you, keep in mind that the ability to conduct trades 24 hours a day might be viewed as a benefit to many, but it can also lead to problems. Those who have a difficult time separating emotion from good trading logic might find themselves over-trading due to the easily accessible market. Many investors like to make a trade and then walk away, not having to worry about the position of their investment during all hours of the day. On the other hand, the vast majority understand that Forex trading is a global activity and that what might be happening across the world at 2 a.m. could present as an important trading indicator at home. In the end, there is no one right answer. However, Forex trading has proven to be lucrative, exciting, and risk-averse for those who want to make serious profits in a short amount of time. The choice, as always, is yours.