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Options are derivative instruments. Usually when the word “options” is mentioned, people instinctively think about stock options. However, stocks are not the only instruments traded as options derivatives. Commodities and currencies are also part of the derivative assets and so when we talk about forex options, we are talking about the practice of trading currencies as derivative instruments.

A forex option is a contract is a derivative financial contract that gives the buyer but not the obligation, to exchange one currency for another, at a pre-determined exchange rate, on a specified date without necessarily owning the physical currency.

Just as the forex market boasts of being the most liquid financial market, the forex options market is the most liquid options derivative market. Forex options can also be traded as futures contracts on the Chicago Mercantile Exchange (CME).

There are two types of forex options.

a)      Traditional options

b)      SPOT or Single Payment Option Trading

Forex Options Trade Example

To demonstrate the way forex options work, we have our trader Mr John who decides to play a forex option on the GBP/USD currency pair (British Pound vs UD Dollar). John sells 1 Standard Lot ($100,000) of the GBP and simultaneously buys 1.5 Standard Lots of the USD ($150,000). Here the pre-determined exchange rate is 1.5000 (or £1 = $1.5), which is also the strike price. This trade is also known as a call on dollar/put on sterling trade, because the trader is buying the USD and selling the GBP. Since the GBP is the base currency in the pair, the trade can also be expressed in terms of the GBP as a GBPUSD put. This is a traditional forex options trade.

Profit Scenario for the Forex Options Trade

If the GBPUSD exchange rate falls to 1.4950, then the trader can exercise the option contract by buying back the contract at the new exchange rate. At this new exchange rate, the trader sells his USD to buy back GBP, spending $149,500 in the process. The difference is his profit, which is the $150,000 realised from the GBP sale, MINUS the 149,500 he is spending to buy back the GBP with USD, = $500

The maximum loss is restricted to the premium on the trade, which occurs if the exchange rate were to rise above 1.5000, causing the forex options contract to expire worthless

 

 

Breakeven Point

If the exchange rate remains unchanged, then we have a breakeven point, though in a fast paced market like the forex options market, it is very rare to see currency exchange rates remain unchanged.

In the SPOT forex options contract, the trader will purchase the contract to bet on an outcome. Mr John may decide to purchase a Touch option for the GBPUSD, using a strike price of 1.4500. If the exchange rate of the GBPUSD touches 1.4500 at any time before expiration, he will receive a payout.

Considerations

There are two styles for the traditional forex options. The American style enables the trader to exercise the forex options contract before expiration, while the European style forex option can only be exercised on expiration. As such, the American style forex options contract is more flexible in nature, as it enables a trader to take profits early or cut losses.