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.
There 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).
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.