Option Trading The Forex Market
A Forex option or FX option is a currency bond between a buyer and a seller giving the option buyer a right but not a commitment to sell or buy a specific amount of currency against another at a predetermined price on or before to a specific date in the future. This date is expiration date and the price is strike price. To get this option the buyer has to pay a one-time sum which is known as “premium”.
Forex option trading is an alternative investment for traders as well as investors. It offers great flexibility to large as well as small investors. This investment tool determines suitable forex trading and hedging strategies to implement.
The basic financial responsibility of an option buyer is to pay the premium to the seller in advance at the time of purchase of the option. Thus, till the expiry the option buyer has no commitment to sale.
The buyer's only financial obligation is thus the premium he must pay to the seller. On the expiration date, a call buyer may exercise his/her right to buy the underlying spot position at the strike price, while a put buyer may exercise his/her right to sell the underlying spot position at the strike price. However, buyers often sell the currency options contract before the expiration date. In option trading, there is no limit to the possible profit of the buyer.
There are mainly two types of option:
1. Traditional call/put option
This option allows the buyer the right but there is no obligation to purchase something from the option seller at a set price and time. Taken an example, suppose a trader purchase an option to buy 10 lots of EUR/USD at 1.3300 in one month; this is known as a "EUR call/USD put."
If the price of EUR/USD is below 1.3300, the option expires worthless, and the buyer loses only the premium. Alternatively, if EUR/USD reaches to 1.4000, then the buyer can exercise the option and gain 10 lots for only 1.3300, which can be sold for profit. Now in this case during purchase of this option if the premium was 10 pips, then by selling at 1.4000, the net profit will be (1.4000-1.3300-10pips).
There are two types of traditional call/put options:
- American-style – This type of forex trading option can be done at any point of time till the expiry of the option.
- European-style – This type of forex trading option can be done only at the time of expiry of the option.
2. Single payment Options Trading (SPOT)
The premium required for this type of option is much more than the traditional option. In spot trading the seller offers a price scenario within a specified period and if the price break come through then the seller gets the cash immediately in his account.
Here also in the loosing side only the premium amount at the time of purchasing the option where as looking the changed scenario if the price break is in favour of seller then profit margin is huge. SPOT is much more preferred in option trading due to the following points:
- If situation is in your favour then you get instant cash and otherwise you loose just the premium amount.
- Spot has multiple choices where as traditional option offers just one fixed choice.
- Downslide is smaller; it’s just the premium amount.
- In SPOT there is freedom to set the price as well as expiration date.
- To minimize risks traders can hedge the spots against cash position.
- When the market is too much volatile you need not to enter into open market position so that your entire capital will be in stake, rather you can risk on premium and still can enjoy profits.
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