There are a number of reasons why options are appealing to traders. Here are some of the main ones:
- Downside risk is limited to the amount you paid to buy the option (the premium) – so unlike cash trades, you can’t lose more than your initial stake.
- The profit potential is unlimited
- The amount of money you have to pay upfront is less than with a spot (cash) forex trade.
- Unlike futures, the price and expiration date of options can be set by the trader, rather than being offered it on a take-it-or-leave-it basis.
- They can be be used as a hedge to limit the risk of open spot (cash) trading positions.
- Options can be a relatively low-risk way of trading major market moving events such as economic reports or policy meetings, as the huge volatility that can often occur after these events can make them too risky to trade with a standard spot trade.
However, there are a few disadvantages to using options too – otherwise, nobody would use anything else to trade the markets. Here are some of the reasons that traders often choose to trade other financial instruments:
- The risk/reward ratio can vary widely according to the strike price and the date of the option, which makes them quite tricky to calculate and include in a risk-management strategy.
- Once you buy a SPOT option, there is no going back – they cannot be sold back or sold on to other traders. This means that the money you invested in the premium is under lock and key until the option expires.
- Predicting the exact time periods and prices at which movements in the market occur can be very difficult, and there isn’t as much flexibility to adapt your trade as time goes on.
- The probabilities associated with trading options aren’t always in the trader’s favour, which means that you have to be very good at predicting in order to make a profit using these instruments.