Forex options are a great way to invest in the forex. This introduction will give you the basic information you need to start understanding forex options and how they can be a great tool for risk control and speculation.
About trading forex options
Forex options are available from certain forex dealers in over-the-counter versions, just like spot forex contracts. If you are interested in setting up a demo account with a dealer that offers forex options, click here. Forex options are also available as exchange-traded securities, which means you will need an options broker to trade them.
You can buy and sell forex options. When you buy, or go long, a forex option, your risk is limited to the amount you paid for the option. When you sell, or go short, an option, your risk is unlimited, just like going long or short a currency pair. In this section we will talk about using options as a long trade. In later sections, we will talk about how you can use options on the short side.
Types of basic forex options
Puts: Put options increase in value if the price of the currency pair drops. If the price of the currency pair rises the put will decrease in value. A put gives you the right to sell a currency pair for a specific price. That means if the price of the currency pair is dropping, your put is going to increase in value because you have the ability to sell the currency pair for a higher price.
Calls: Call options increase in value if the price of the currency pair rises. If the price of the currency pair drops the call will decrease in value. A call option gives you the right to buy a currency pair for a specific price. That means if the price of the currency pair is rising, your call is going to increase in value because you have the ability to buy the currency pair for a lower price.
Characteristics of forex options:
Expiration: Forex options are only good for a specific amount of time. You can choose the expiration date when you first purchase the option. For many of the strategies we use at PFX, buying an option that expires in 30 days is usually sufficient Sometimes you may need to sell the option before expiration to prevent it from expiring worthless.
Strike price: Forex options have a specific strike price attached to them. If you buy a call on the GBP/USD because you think it will rise in value, the strike price is the fixed price at which you could buy the GBP/USD. If your strike price was 2.0000 and the currency pair was priced at 2.0250, you would have the ability make a profit of 250 pips by exercising that option. But you don’t actually have to exercise the option to make a profit. You can simply sell the option back on the open market, and make the same profit.
Although there are many strike prices to choose from, in this lesson, we will concentrate on the at-the-money strike price, which is equal to the current spot price. In a later lesson, we will talk about out-of-the-money and in-the-money strike prices and how you can use these in other options strategies.
Leverage: Over-the-counter forex options enjoy the same flexible leverage you enjoy with spot forex contracts. The exchange-listed forex options described above control around 10,000 units of the base currency, just like a mini-spot contract. If a contract costs $190 your leverage is approximately 50:1. That is comparable with a forex spot contract.
Strategy #1—Speculating with a long option
Let’s assume that you think the EUR/USD is going to rise during the next week or two. To take advantage of this rise, you could buy the forex contract or buy a call option. The call is a good alternative because it has a fixed amount of risk associated with it but could still accumulated unlimited profits. In the video, we will cover this situation and show you how the call increases in value as prices change. If you are analyzing a pair that you think will decline in value, you could buy a put instead of a call to take advantage of the downside opportunity.
Because you cannot lose more than the amount you paid for the call or put option, the option acts like a stop loss. Most traders will not hold an option until it becomes worthless. But if you were determined not to exit the trade, at least you know that you won’t be surprised by the worst case scenario.
Strategy #2—Hedging risk with a long option
Assume you are long the AUD/USD and that the pair is close to resistance, but you believe it is going to break up through resistance and continue moving higher. A surprise decline could eat a lot of profits very quickly, and you want to protect your position. You could set a stop loss that is close to the market, but you have a very high chance of being stopped out on a whipsaw. This is a very common frustration for new and old forex traders. What if instead of setting a stop loss, you bought a put option?
If you buy the put and the pair drops, your gains on the put will offset the losses on the pair itself. This will caps your losses to the downside. If the pair rises, the put will lose value, which will partially offset some of your gains on the pair. But as long as the potential gains are greater than the cost of the put, the trade is still worth it. We will cover this trade and its potential outcomes in this lesson’s video.
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Watch the video below to see more about forex options, then...you've finished the Forex Essentials course!
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Forex Essentials Course - 21 lessons:1. What is the forex
2. Supply and Demand
3. How Trading Works - Interbank and the Forex
4. Choosing a Dealer
5. Forex Pairs - Characteristics and Qualities
6. Earning Interest in the Forex
7. Margin and Leverage
8. Short Term vs. Long Term Trading
9. Forex Futures vs. Spot Forex Accounts
10. Fundamental Analysis in the Forex
11. The Calendar and Economic News
12. Introduction to Charting and Technical Analysis
13. Support and Resistance
14. Fibonacci Analysis
15. Price Patterns
16. Continuation Patterns
17. Reversal Patterns
18. Technical Indicators
19. Portfolio management – Diversification
20. Portfolio Management - Position Sizing and Stop Losses
21. Introduction for Forex Options