Guide to Forex Options Trading Part 1: Traditional Options

Although options are more commonly associated with the stock market, these financial derivatives can also be used to trade the currency markets. Although it can be quite a bit more complicated than trading spot forex, it does provide you with some useful tools for limiting risk and increasing profit.

fx-options-forexthinkThere are two main types of option available to online forex traders: traditional call/put options, and the more flexible single payment option trading (SPOT, not to be confused with non-options based spot trading).

Traditional Options

A traditional call/put option provides the buyer with the right – but not the obligation – to buy something from the seller of an option at a particular time and price. So, a trader could purchase an option to buy two lots of USD/JPY for 100.00 in 30 days’ time. This contract would be known as as “USD call/JPY put”.

As in the cash market, when you buy a call, you simultaneously buy a put. If the price of USD/JPY is below 100.0 when the option expires in a month’s time, the option is worthless. If, however, the USD/JPY soars to 110.00, then the buyer can exercise the option and obtain two lots for the price of 100.00, which can then be sold for an instant profit.

As a derivative that is traded over-the-counter (OTC), traders of forex options can choose the date and the price at which the option is to be valid, and get a price for the purchase of that option.

Traditional options come in two basic forms: American-style, and European-style. American-style options can be exercised at any point up until expiration, whereas European-style options can be exercised only at the point of expiry.

There are a few potential advantages to traditional options as opposed to SPOT options. The main factor here is that the premiums tend to be a lot lower. Another is the fact that American-style traditional options can be bought and sold before they expire, which gives the trader more flexibility. However, traditional options can be a bit more difficult to set and execute than SPOT options.