When and why should I use Forex options?

What do we do with FX Options?
We obtain the right to buy or sell currency for the strike price on the expiry date.
We have no obligation to exercise this right.
The Premium is the cost we pay.

How does an FX Option work?
The option price consists of intrinsic and time value.
There are FX Call and FX Put Options for both market directions.
American options can be exercised anytime on or before the date of expiration.
European options can only be exercised on the date of expiration.

When and why should I use currency options?
Your risk is limited to the price of the option.
Traders trade market volatility, or they trade without classic stop-loss strategies.
Portfolio managers and businesses hedge Forex risks.

How are FX options traded?

FX option traders can use the 'Greeks' (Delta, Gamma, Theta, Rhio and Vega) to judge the risks and rewards of the options price, in the same way as you would equity options.

The risk for an option buyer is limited to the cost of buying the option, called the 'premium'. An option buyer has theoretically unlimited profit potential. Conversely, for an option seller the risk is potentially unlimited, but the profit is fixed at the premium received.

Access to FX options

FX option contracts are typically traded through the over-the-counter (OTC) market so are fully customisable and can expire at any time. In the spot options market, when you buy a 'call', you also buy a 'put' simultaneously. For example, a trader might buy an option for the right to purchase one lot of EUR/USD at 1.00 (or parity) in three months. This is a 'EUR call/USD put'.

FX options are also available through regulated exchanges which are options on FX futures, in which case it is simply a call or a put. These offer a multitude of expirations and quoting options with standardised maturities. When traded on an exchange, FX options are typically available in ten currency pairs, all involving the US dollar, and are cash settled in dollars.

Why trade FX options?

One of the most common reasons for using FX options is for short-term hedges of spot FX or foreign stock market positions. For example, if you were buying EUR/USD but you thought there might be a short-term decline in the price, you could also buy a euro put option to profit from the decline while maintaining your buy. You could also sell EUR/USD short at the same time as buying.

There are many bullish, bearish and even neutral strategies that can be implemented with options contracts. Spread strategies that are used in equity options can also be used with FX options, including vertical spreads, straddles, condors and butterflies.

An FX option can either be bought or sold. Options prices are derived from the base currency, which is the first currency in the currency pair (eg euros in EUR/USD). If you are bullish on the base currency then you should buy calls or sell puts, conversely if you are bearish you should buy puts or sell calls.

Why do we use FX Options?

The FX Options market is the options market with the highest depth and liquidity in the World. Market participants can use different strategies for limiting risks and increasing profits.

Traders: Fixing potential risks

If the FX rate moves against our position in the FX spot market, we have a loss. By acquiring a Forex Option, we can remove the risks of unpredictable losses; our minus will always be limited to the Premium then.

This strategy works like an insurance contract. If the market moves against us, the option protects us by limiting and fixing the potential minus. On the other hand, we can still profit from favorable FX rates should the market move in our direction.

FX options have the advantage that the upside is unlimited. At the same time, we can only lose what we have paid for the contract. Thus, we can develop sophisticated trading strategies. Because you cut your losses and speculate for potentially unlimited wins, you don’t need to win 50% or more of your trades.

Since we know our maximal loss before, position sizing in the spot market can happen with easy and predefined strategies. Another advantage for traders is that they can work without stop-losses for open positions in the spot market. Buy a contract and let the markets decide. Forget about permanently checking your stop-losses, which only leads to mental mistakes – Peace of mind.

Hedging with FX Options

This type of option is also beneficial for hedging FX risk in portfolios when the direction of movements in exchange rates remains uncertain for some time. That’s why Forex Options are handy financial derivatives, especially for portfolio managers.

Currency market turbulences and massive exchange rate fluctuations can happen due to unforeseen events in the World economy or politics. By utilizing FX Options, we can protect ourselves against these sudden movements in exchange rates.

Contrary to the purchaser, the option seller’s risk is potentially unlimited. He will always receive the fixed Premium for taking over the risk. That’s why an option seller needs a considerable amount of liquidity.