What Are Options?

Options are one more tool that could be harnessed in forex trading. These securities can potentially help manage the risks involved with the global currency markets. Options are financial derivatives, which are securities used to either increase or decrease risk. By entering one of these contracts, a participant is wagering on a certain outcome.

If you are looking to learn more about derivatives and their use in both investing and risk management, options may be a good place to start, as they can be simpler than many other derivatives contracts. In this article, we will help build the foundation so you can learn about options and how they pertain to forex trading.

Options Defined

An option is a contract that grants the holder the right, but not the obligation, to either buy or sell an underlying asset or market factor during a specific time frame. A call option grants its owner the ability to "call away" or buy an underlying asset, while a put option provides the purchaser the right to "put" or sell the underlying asset.

Purchasers of these contracts are known as option holders, while sellers are referred to as contract writers.

After acquiring an option, a buyer can either exercise the contract, sell it or let it expire. The seller, on the other hand, is at the mercy of the buyer. At this point, you might wonder why a person or organisation would want to give someone else rights to its securities. The answer is that by writing a call or put, the individual or entity can earn income in exchange for granting such rights.

Forex Trading

Investors interested in forex trading can use options in an effort to try to meet their investment objectives. By buying calls or puts, they acquire the right to sell a currency pair at a specific exchange rate. In contrast, writing options on these underlying assets can generate income for sellers.

For example, if you believe EUR/USD, which is the euro-dollar exchange rate, will appreciate over the next several months, you could purchase a call option on the pair. Let's say EUR/USD is trading for 1.00, but you think it might rise in the next few months, potentially reaching as much as 1.10.

In this instance, you could buy a call on this pair with a strike price of 1.05 and an expiration date set several months from now. Should EUR/USD climb, your call option will also rise in value. Therefore, you will have the ability to either sell the contract for a profit or exercise it and purchase the currency pair for 1.05.

However, if you buy a call option on the EUR/USD and the currency pair declines, the contract you bought will fall in value. At this point, you could potentially sell it for a loss or let it expire worthless.

Alternatively, if you think EUR/USD will lose value in the coming months, you could place the opposite trade, purchasing a put option on the exchange rate. If the currency pair is trading at 1.00 right now, and you predict it will fall to 0.90 within the next six months, you could buy a put option on EUR/USD with a strike price of 0.95 and an expiration of a year from now.

Should the currency pair decline in value, you may be able to sell the put option for a profit or exercise the contract, selling EUR/USD for the strike price of 0.95. In the event the pair appreciates, the put you purchased will lose value.

Writing Options

Writing call and put options can provide investors with income. However, it can also generate losses.

If forex traders want to harness a basic options writing strategy, they can sell call options on assets they own, which creates income. This strategy, referred to as covered calls, is viewed by many as being less high risk, as the risk is limited.

Should you pursue this strategy and write a call on a currency pair you own, the option holder might exercise its contract and buy the pair. In the event this happens, your risk is limited to the rise in value the underlying asset experienced, minus the income you brought in. While this may not sound substantial, consider the potential loss if you buy a currency pair and its exchange rate surges 25% or more over the course of several months.

An alternative strategy is selling naked calls, which involves writing options contracts on assets you don't own. Many perceive this approach to be highly risky. If you provide someone the right to purchase a currency pair at a certain price and the pair surges in value, you could incur substantial losses. Fortunately, many brokers will not allow investors to write naked calls unless they have a large balance in their account or have accumulated substantial experience.

For those who want to generate income from puts, selling currency puts could help them achieve this specific objective, if the value rises. Generally, investors write puts on securities in the belief they will rise in value. If a forex trader sells a put on a currency pair they think will appreciate and this forecast comes true, they can simply collect the premium without having to worry about the holder exercising the contract.

Should the pair fall in value, the forex trader who wrote the put may find himself having to buy back the currency pair at a fixed price, which could result in a loss.

Important Considerations

Options trading can prove highly profitable for those who wager correctly and generate steep losses for those whose bets don't turn out as planned. One simple example of this nature is the risks and rewards associated with purchasing call options. If an investor believes a currency pair will rise in value, buying call options reflecting that belief can generate far greater returns than purchasing the pair outright.

However, if the trader's wager turns out to be inaccurate, he could lose all the money he used to buy the option, along with any transaction costs.

While buying options comes with limited liability, selling options contracts has potentially unlimited liability. If an investor sells a naked call, he could face unlimited losses.

Because options could provide both significant opportunity and substantial risk, investors can benefit greatly from conducting substantial research on the subject and/or obtaining advice from an independent financial adviser.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.