Forex Options: The Basics

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forex optionsWhen talking about Forex derivatives, people usually tend to neglect Forex options in favor of Forex forwards, futures or sometimes even swaps. Unlike forwards which typically require no down payment and futures which are both legally binding and costly, options offer more maneuvering space albeit at higher cost; you don’t have to actually activate the option if you don’t want to, but you still have to purchase it beforehand, and there is no refund policy for unused options. Still, it’s usually cheaper than committing to a more serious trade.

Forex options

Forex options are contracts which award their holders the right to buy or sell a currency at a certain price and within a certain time period, provided the market conditions are favorable. Otherwise, the holder can simply let the option expire, just like on other markets and move on without any liability, which is a stark contrast to forwards and futures. Other than that, the conditions are standard for all three and function similarly. Here’s how it works in real life: Let’s say the current EUR/USD pair is at 1.14363. You wish to buy €100,000 but don’t have $114,363 plus expenses. You have $3,000 and expect to have the funds in three months. You believe the Euro will increase in value dramatically in a few months, but can’t be certain; plus you’d rather not commit because you’re not 100% sure. So, you trade the $3,000 that you do have on Forex options and wait for three months. One of three things will happen: a) your hunch was on the money, the value is much greater, so you activate the option, buying at the prearranged rate and selling for the spot value, netting a nice profit. b) you’re still right, but you don’t have the money or something happened and you can’t make the trade; you cut your losses at $3,000 and move on. c) you were wrong, the price has gone in the opposite direction, and your plan essentially boils down to b). Or, you get swindled and lose your money, but this is unlikely in this day and age; possible, but unlikely.

Types of Forex options

There are call and put options; call options allow you to acquire currency while put options allow you to sell it at a certain rate. In the first case, you’re hoping the price will go up so you can buy it cheaply and sell at spot value and in the second case you’re expecting the price to drop so you can buy it cheaply and sell at a higher rate. Writers are the people who sell options and holders are the ones who buy options. Note that buying and selling options is not the same as buying and selling the underlying instruments. The writer of (Forex) call options promises to sell the currency whereas the writer of a put option promises to buy it. The holder is the one calling the shots. You can find out more about options by checking www.optionsway.com.