In the previous instalments, we’ve looked at the differences between the various types of option. Today, we’re going to look at an example of how an option might be practically used in a forex trading situation, and also the two main uses that options can be put to.
Forex Options Trading Example
Let’s say it’s the 2nd of January, 2014. an you have reason to believe that EUR/USD – currently sitting at 1.3000 – is on the way down on the back of positive economic reports from the US. However, there are several major economic reports on the way that have the potential to cause massive price volatility. You think this is likely to happen over the next couple of months, but because of the risk involved with taking a cash position on this presumption, you decide to use options instead.
Therefore, you place a EUR put/USD call – which is commonly referred to as a EUR put option at a strike price of 1.2900 that expires on Feb 2, 2014. You are informed by your broker that this option has a premium of 10 pips, and you decide to buy.
If you were to break it down, this order would look not dissimilar to this:
Buy: EUR put/USD call
Strike price: 1.2900
Expiration: 2 February 2014
Premium: 10 USD pips
Cash (spot) reference: 1.3000
Ok, let’s flash forward a little in our hypothetical situation to witness the EUR/USD pair falling to 1.2800. Seeing the opportunity to make a quick profit, you exercise the option, which gives you 90 pips of profit. Here’s how this is worked out:
Strike price 1.2900 – market price 1.2800 – 0.0010 premium = profit of 90 pips
There are many ways in which options can be employed by traders, but for the most part, they are used either to capture profit or as a hedge against existing positions.
The fact that you can’t lose more than the premium makes options quite useful in trading situations where the risk level might be too high to perform a cash trade, but there is a significant profit opportunity in the offing. This is why many forex traders turn to options to trade major news releases, such as the US nonfarm payroll report, when the level of risk – and the spreads offered – tends to increase.
However, the fact that options tend to be cheaper, in terms of the amount of money that you could lose on each trade, than a cash trade. In many circumstances, an options position has the potential to make a lot more money than a cash position for the same amount.
When you have an open position that you suspect may go against your prediction, options can be a useful way to decrease the level of risk. They can be considered as an adjunct to stop losses, with the added bonus that if the price continues to move against your position, the profit potential is unlimited, unlike the loss potential on the original trade which is limited by the stop.