Introduction to Forex Options
Forex options represent another way to trade the forex market. What are forex options? Forex options are securities that allow forex traders to purchase or sell contracts based on the movement of the underlying currencies without actually holding the currencies in question. Forex options give the trader the right to purchase or sell a currency in exchange for another currency at an agreed price and on a pre-determined date, without an obligation to complete this transaction at the said price or date.
Of all forms of option trading, the forex options market is the most liquid market of all. Forex options represent a way to trade the FX market as a hedge against spot FX positions. Institutional traders use forex options for this purpose so that if a spot forex position goes against the trader's expectations, the FX options trade can be used to hedge it and cover any losses that may have been incurred on the other trade.
Specifically, these are the advantages that traders can get trading forex options:
a) Offsetting the effect of losses on the trader's portfolio from a losing trade in the spot forex arena.
b) Can be used exclusively as a means of financial investment by substituting the forex option for a spot forex trade.
c) Can be used to make money from forex even when the asset is trading in a tight range. This requires knowledge of the right type of option trade for it to work.
WHERE TO TRADE FOREX OPTIONS
FX Options can only be traded through selected brokers. Some of these brokers are listed below:
- Charles Schwab
- Fidelity Investments
- GAIN Securities
- Interactive Brokers
- TradeStation Securities
- Saxo Bank
Trading forex options usually requires a higher degree of margin because of the cost of each trade. Typically, a single trade contract consists of 100 units of the underlying asset. FX Options trades are usually cleared on the International Securities Exchange.
TYPES OF OPTIONS TO TRADE
There are many ways to trade an FX options contract. You can trade straddles, strangles, covered calls, credit spreads, butterfly spreads, naked calls and puts, iron condors, bear and bull call spreads, bear and bull put spreads and so on. It is advisable for the trader to start from the simplest options trading style and as experience is gained, the more complex trade versions could be added to the trading profile. We will give some illustrations of how to trade forex options using two of the styles that have been mentioned above.
Selling Covered Calls
One strategy you can adopt is by selling a covered call. You sell a covered call under the following conditions:
a) You have a long position on a currency pair in the spot forex market which has made some gains.
b) You expect the price of the currency pair to continue rising until expiration of the option trade.
In selling a covered call on an asset, the trader is paid a premium by the broker, which is credited to the trader's account when the trade is executed. In other words, the broker is paying you for selling the spot forex position to him. If the asset goes higher, then the forex option holder keeps the premium and the previous profit from the spot forex trade. This is because as soon as the forex option trade is made by selling the spot forex position to the broker as a covered call contract, the broker now owns the spot position and the trader cannot profit from it.
Scenario 1 is the simplest way to sell a covered call, and is something every trader can do without stress. The only requirement is for the asset to keep rising, after some initial gains, so the trader should be looking for an opportunity to get into a trend early, then find a continuation chart or candlestick pattern to play the rest of the trade.
This scenario is more complex as the trader will need the price to move in two directions, one after the other. This cannot always be predicted with certainty but is a possible scenario that could occur with covered calls, so you need to know how to trade it if this occurs.
a) As in Scenario 1 above.
b) The price action of the currency pair drops below the entry price of the forex option trade (but still stays above the entry for the spot trade), then starts to rise after expiration.
Here, the trader keeps the premium from the trade. Since the asset starts to rise after expiration, the trader will also profit from the rising spot trade.
a) The asset drops continuously.
Here, the spot position's profits will start to be eroded. The trader should mark the break even point for the spot trade (i.e. the entry price for the spot position). When the asset price gets to this point, the trader must exercise his option to save the premium, because this is the only profit left to make. The forex option is exercised by buying back the call option.
This is one example of a way to trade forex options. We will give more examples in subsequent articles.