The first thought of most people upon hearing about options are stock options. However, options are also available of the foreign exchange market. These derivatives afford opportunities to retail FOREX traders to limit their risk and increase profits on any particular exchange.
Types of Options
Retail FOREX traders in Australia have several types of options available to them. The two general types of options available are traditional options, also called call/put options, and single payment option trading, or SPOT options. Call/put options for FOREX trading work in a similar manner as stock options, whereas SPOT options are more flexible.
Traditional options give the holder the right to buy or sell a named underlying asset at a specific fixed price during a specific period of time. At no time is the holder obligated to buy or sell. Instead of exercising the right to buy or sell, the holder may simply allow the option to expire. In the case of FOREX options, the underlying asset is a currency to be bought or sold in exchange for another currency.
An example would be an option for a set amount of EUR/AUD at 1.30 to expire in one month. This example would be a EUR call/USD put. In the currency market, a call and put option are bought simultaneously. If, after the month, the exchange rate for EUR/USD is under 1.30, the option is worthless and allowed to expire. The holder is out only the premium paid for the option. If, however, the EUR/USD exchange rate suddenly moves up to 1.35, the holder can exercise the rights of the option and buy at 1.30 and turn around and sell on the FOREX market for 1.35.
FOREX options are traded on an over-the-counter basis. This allows traders to negotiate the terms and expiration of the option. The terms and the specific underlying currencies will affect the premium that must be paid to purchase the option. Traditional options benefit from having lower premiums than SPOT options. On the downside, they are little more difficult to originate than SPOT options.
In Australia, two types of call/put options are available:
• American-style options – These options allow for the holder to exercise them at any time before the expiration date.
• European-style options – These options can only be exercised on the expiration date.
Single payment options trading options work differently than traditional options. SPOT options are a very streamlined alternative. The buyer gives a scenario to a broker and is quoted a premium. A scenario is in the form of a currency exchange, an exchange rate, and time period. An example of a SPOT option scenario is EUR/AUD will break 1.38 in 15 days. If the scenario comes to pass, the holder automatically receives a payout. The automatic conversion of the option to cash is a big selling point to many options buyers. SPOT options allow many additional choices not offered with traditional options. The increased choices, ease of purchase, and automatic payout all make SPOT options an appealing financial product. In exchange for the increased flexibility and ease-of-use, SPOT options suffer from having higher premiums than traditional options. Some of the choices available with SPOT options are as follows:
• Digital SPOT – The buyer receives a payout if the price at the end of the term is above or below the specified level.
• One-touch SPOT – The buyer receives a payout if the price meets a specified level.
• No-touch SPOT – The buyer receives a payout if the price doesn’t meet a specified level.
• Double one-touch SPOT – The buyer receives a payout if the price hits one of two specified levels.
• Double no-touch SPOT – The buyer receives a payout if the price hits neither of the two set levels.
Pros and Cons of Options
Options are a very appealing investment product for many traders. Some of the top reasons for such appeal include the following:
• The risk in the investment is never more than the price of the premium when the option was purchased.
• The potential profit from options is unlimited.
• In FOREX, SPOT options allow for a lower upfront payment.
• The rates and expiration dates are negotiable. The buyer has the choice of both.
• Options can work as a hedge on cash positions, limiting the risk of losses.
• Options can be used to trade on predicted market movement for a low upfront cost and without huge risks. Options are very popular right before important economic reports are scheduled to be released.
Options also have a downside. Some people shy away from options for the following reasons:
• The ratio of risk to reward varies greatly depending on the strike price and expiration of the option because these factors affect the premium.
• Once purchased, SPOT options are non-negotiable. They cannot be traded or sold.
• Options require precise timing based on the expiration. Predicting movements in FOREX for strict time periods can be difficult.
• Options have not always been shown to be a sound long-term financial strategy.
The premiums and values of options rely on several factors working in conjunction. The value of options is determined by these factors:
• Intrinsic value – This is the value of the options should they be immediately exercised. The intrinsic value can be in one of three positions.
o In-the-money – The strike price is greater than the current FOREX market price.
o At-the-money – The strike price is equal to the current market price.
o Out-of-the-Money – The strike price is less than the market price.
• Time Value – This is a representation of the uncertainty in the price over a period of time. The time value is usually greater the longer the time. As the expiration approaches, the time value diminishes.
• Interest rate differential – The difference in the interest rates of the two currencies affects the strike price and the market rate.
• Stability/Volatility – Stable currencies have less of a chance of hitting a particular strike price within a limited period. More volatile currencies have a greater chance of hitting a strike price. Volatile currencies usually have higher options premiums than stable currencies.