As Foreign Exchange (Forex) markets comprise the largest volume of monetary values traded on a daily basis when compared to every other financial market and asset class, it is no coincidence that one such popular method of trading currencies include forex options trading – also known as currency trading options.
An option is a right but not an obligation to buy or sell an underlying asset class at a specified strike-price, and the right of which can be bought or sold either on an exchange (exchange-traded) or in the over-the-counter (OTC) markets (off-exchange).
The owner of an option contract can exercise this right to buy or sell, up until expiration of the contract at which point the option expires worthless if not exercised. In addition, as will be revealed below, sellers of options, known as writing options, carries its own set of differences when compared to buying options, and understanding currency trading options can be a valuable tool in a forex trader’s portfolio.
Forex Options Trading Explained
This right or option to exercise the contract at the specified rate, and for a specific quantity of currency, when buying or selling the underlying asset, is conveyed from buyers to sellers and vice-versa (from sellers to buyers).
There are typically four basic ways to trade options, although many strategies and combinations exist, the main types of trades can fall into the following four categories:
- Buy the Right to Buy – Call Option (LONG CALL)
- Buy the Right to Sell – Put Option (LONG PUT)
- Sell the Right to Buy – Call Option (SHORT CALL)
- Sell the Right to Sell – Put Option (SHORT PUT)
Although the share of forex options trading overall doesn’t dominate the majority of FX market volumes, it still represents a meaningful share of trading and thus can be a viable instrument and method to consider when investing or trading foreign exchange.
When Time is Money with Forex Options
Two terms often described alongside options include their intrinsic value and their time-value, as these two variables are forms of measurements, whereas the “intrinsic value” measures the difference between the market value of the underlying spot rate and the option strike price, and where the “time-value” aims to estimate the discounted expected value of that difference at expiration.
The degree of intrinsic value an option has is referred to as how much “in-the-money” it is, whereas an option that is “out-of-the-money” has no intrinsic value, although may still have extrinsic value within any remaining time-value. The way that such measurements are made depends also on what type of option position is being taken, whether a Call is being bought or sold, or whether a Put is being bought or sold, as will be described below.
Puts and Calls: The Right to Buy or Sell is Being Bought and Sold.
Just like options on nearly any financial instrument, in foreign exchange, call options involve the right to buy – and put options convey the right to sell -an underlying instrument at a specified exchange rate, and premiums are paid by buyers and earned by sellers when carrying out forex options trading.
Options contract are typically for a pre-determined quantity of an underlying asset, and will vary depending on the contract specifications of the broker or exchange operator, as well as the specific instrument being traded, such as an underlying currency pair.
Options are divided into Puts and Calls, whereas a “Call” is the right to buy an underlying asset at a specified strike-price, and where a “Put” is the right to sell an underlying asset at a specified strike-price.
However, Buying or Selling either of these option types can have very different consequences. For example, buying a call gives the buyer the right to buy at the underlying strike-price of the option, whereas selling a call requires that the seller must be able to deliver the underlying asset and sell it to the buyer at the underlying strike-price if the buyer decides to exercise their option prior to expiration.
Moreover, each option contract conveys a quantity of the underlying asset that will be traded if the contract is exercised by the party that has the right to exercise their option. The diagram below highlights the how the buying or selling a put or call can vary in its potential profitability depending on market direction, and factoring in the premium into the cost of the trade, in order to determine the payoff level:
Example of Forex Options Trading
For example a September call option for 100,000 EUR/USD @1.4250 implies that the buyer of that call would have the right to buy 100,000 EUR/USD in September at a rate of $1.4250 per Euro, regardless of what the spot rate will be at that point in time, if they decided to exercise their option before it expired.
Therefore, if the EUR/USD rate was trading today at $1.3300 and a trader was expecting that it might go to $1.42 by September, buying the above mentioned call could be one way to potentially capture that movement, whereas the downside would be the cost of the trade, which is the premium paid by the buyer, in the event the option was not exercised, such as in the case where if the spot rate in September was more favorable than the contract offered, or if the buyer simply changed their mind.
On the other hand, if the buyer had purchased a put option – which conveys the right to sell, for example at the above mentioned rate of $1.42 for 100,000 Euros, and the spot rate was under that price by the time the option could be exercised, the difference would be a gross profit, as the buyer could exercise the right to sell at $1.42.
Examples Used Above:
- Buy 1 September Call Option for 100,000 EUR/USD @ $1.42
- Buy 1 September Put Option for 100,000 EUR/USD @ $1.42
In the same scenario above, if the trader was instead a seller of options, and sold an option for someone else (a buyer) to buy 1 September call option for 100,000 EUR/USD @ $1.42 then the seller would receive the premium and the buyer would have the right to exercise the contract around time of maturity and prior to expiration.
In the event the buyer of this option exercised the contract, the seller would technically need to deliver the underlying EUROS in exchange for the US Dollars the seller was paying to purchase the 100,000 Euros at the underlying strike price. Conversely, if the seller was instead selling a right to sell, such as in the case of selling 1 September Put Option for 100,000 EUR/USD as $1.42, then the buyer of the put would have the right to sell 100,000 EUR/USD @ $1.42, and if exercised the buyer would need to buy the 100,000 euros that the seller was exercising.
- Sell 1 September Put Option for 100,000 EUR/USD @$1.42
- Buy 1 September Put Option for 100,000 EUR/USD @$1.42
When calculating results, the premium paid or received must be factored into the strike price relative to the spot rate, and will be either deducted or added depending on whether it is a long or short call/put.
Platform Handling Matching, and Delivery versus Cash-Settled
Keep in mind that thanks to modern trading platforms and matching engines the counter-party to trades is typically mitigate to the principal broker or a 3rd party such as in the case of an agency broker, whereas clients do not need to deal with other clients or traders that may be on the other side of the trade.
In addition, the settlement terms for each contract specification should be understood prior to engaging in options trades, since some transactions are cash settled, where like some futures or other commodity related transactions there is no delivery of actual commodities taking place, and/or no need to receive and store such shipments of goods. Rather the trade is cash-settled and paid in full to net-it-out.
At any rate, the customer is relying on their broker to make good on a transaction, and this should be outlined in the customer account agreement which governs the nature of the relationship including from a legal perspective.
Forex Blog recommends WorldWideMarkets which offers investors the ability to choose from multiple trading platforms when opening a live forex trading account or demo forex trading account.
WorldWideMarkets Frequently Asked Questions (FAQ) section described Forex Options premiums as follows:
An option premium is the price of the option. An option’s premium consists of two components:
- Intrinsic Value is the amount that the option is in-the-money. It is the amount that you would receive if you were to immediately exercise the option.
- Time Value is the additional amount that people are willing to pay over and above the intrinsic value. The sum of Intrinsic Value plus Time Value equals the Option Premium. So, if an Option Premium is 5.25 and its Intrinsic Value is 3.00, the Time Value is 2.25