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Many people think of the stock market when they think of options; however, the foreign exchange market also offers the opportunity to trade these unique derivatives. Options give retail traders many opportunities to limit risk and increase profit. Here we discuss what options are, how they are used, and which strategies you can use to profit.

There are two primary types of options available to retail FOREX traders. The most common is the traditional call/put option, which works much like the respective stock option. The other alternative is single payment option trading--or SPOT--which gives traders more flexibility.

Traditional Options

Traditional options allow the buyer the right but not the obligation to purchase something from the option seller at a set price and time. For example, a trader might purchase an option to buy two lots of EUR/USD at 1.3000 in one month; such a contract is known as a "EUR call/USD put." (Keep in mind that, in the options market, when you buy a call, you buy a put simultaneously--just as in the cash market you buy one currency and simultaneously sell another.) If the price of EUR/USD is below 1.3000, the option expires worthless, and the buyer loses only the premium. On the other hand, if EUR/USD skyrockets to 1.4000, then the buyer can exercise the option and gain two lots for only 1.3000, which can then be sold for profit.

Since FOREX options are traded over-the-counter (OTC), traders can choose the price and date on which the option is to be valid and then receive a quote stating the premium they must pay to obtain the option.

There are two types of traditional options offered by brokers:

American-style This type of option can be exercised at any point up until expiration.

European-style This type of option can be exercised only at the time of expiration.

One advantage of traditional options is that they have lower premiums than SPOT options. Also, because (American) traditional options can be bought and sold before expiration, they allow for more flexibility. On the other hand, traditional options are more difficult to set and execute than SPOT options.

Single Payment Options Trading (SPOT)

Here is how SPOT options work: the trader inputs a scenario (for example, "EUR/USD will break 1.3000 in 12 days"), obtains a premium (option cost) quote, and then receives a payout if the scenario takes place. Essentially, SPOT automatically converts your option to cash when your option trade is successful, giving you a payout.

Many traders enjoy the additional choices (listed below) that SPOT options give traders. Also, SPOT options are easy to trade: it's a matter of entering the scenario and letting it play out. If you are correct, you receive cash into your account. If you are not correct, your loss is your premium. Another advantage is that SPOT options offer a choice of many different scenarios, allowing the trader to choose exactly what he or she thinks is going to happen.

A disadvantage of SPOT options, however, is their higher premiums. On average, SPOT option premiums cost more than standard options.

Why Trade Options?

There are several reasons why options in general appeal to many traders:

So, why isn't everyone using options? Well, there also are a few downsides to using them:

Options Prices

Options have several factors that collectively determine their value:

How It Works A Scenario

Say it's January 2, 2004, and you think that the EUR/USD (euro vs. dollar) pair, which is currently at 1.3000, is headed downward due to positive U.S. numbers; however, there are some major reports coming out soon that could cause significant volatility. You suspect this volatility will occur within the next two months, but you don't want to risk a cash position, so you decide to use options.

You then go to your broker and put in a request to buy a EUR put/USD call, commonly referred to as a "EUR put option," set at a strike price of 1.2900 and an expiry of March 2, 2004. The broker informs you that this option will cost 10 pips, so you gladly decide to buy.

This order would look something like this:

Buy: EUR put/USD call

Strike price: 1.2900

Expiration: 2 March 2004

Premium: 10 USD pips

Cash (spot) reference: 1.3000

Say the new reports come out and the EUR/USD pair falls to 1.2850--you decide to exercise your option, and the result gives you 40 USD pips profit (1.2900 1.2850 0.0010).

Option Strategies

Options can be used in a variety of ways, but they are usually used for one of two purposes: (1) to capture profit or (2) to hedge against existing positions.

Profit Motivated Strategies

Options are a good way to profit while keeping the risk down--after all, you can lose no more than the premium! Many FOREX traders like to use options around the times of important reports or events, when the spreads and risk increase in the cash FOREX markets. Other profit-driven FOREX traders simply use options instead of cash because options are cheaper. An options position can make a lot more money than a cash position in the same amount.

Hedging Strategies

Options are a great way to hedge against your existing positions to decrease risk. Some traders even use options instead of or together with stop-loss points. The primary advantage of using options together with stops is that you have an unlimited profit potential if the price continues to move against your position.

Conclusion

Although they can be difficult to use, options represent yet another valuable tool that traders can use to profit or lower risk. Options in FOREX are especially prevalent during important economic reports or events that cause significant volatility (when cash markets have high spreads and uncertainty). Below are some brokers that offer options services:

Resources

FOREX Options Broker: Saxobank.com

FOREX SPOT Option Broker: RefcoSPOT.com

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