What is a forex option and should you trade it?

Forex traders have the freedom to choose between different forex products from CFDs to futures and options. Options, in particular, are an increasingly popular asset class favored by highly leveraged traders due to their significant profit potential.

Certain types of Forex options are derivatives that give their holders the right but not the obligation to buy and sell currency pairs on a specific date at a specific price, which is also called a strike price.

What traders need to know about forex options

• Options are always time-bound and consist of a strike price and expiration date. The strike price needs to be met before the contract expires in order for it to be profitable
• There are four types of options – Buy Call, Buy Put, Sell Call, Sell Put
• Buyers of certain types of Forex options benefit from high volatility before the contract expires
• Options trading is a great way to hedge risks in the market

Option contract types

There are four major option types. Understanding all of these types is important as they have their specific usage and offer specific benefits and downsides.

Buy Call

Investors purchase Buy Call options when they are expecting the underlying asset price is going to rise before expiration. Buy Call option holder has the right to buy but not an obligation, which limits the downside risk to only the premium that was paid for the option. In addition, the profit potential is unlimited.

Buy Put

Investors purchase Buy Put options when they are expecting the underlying asset price to drop before expiration. Buy Put holders can sell the asset any moment before expiration at a price called strike price. Buy Put option holder has the right to sell but not an obligation, which limits the downside risk to only the premium that was paid for the option. In addition, profit potential is unlimited. The more underlying asset price drops before the option expiration date, the higher the returns.

Sell Call

Traders Sell Call options when they are expecting that price will remain the same or will fall. The profit potential is limited, while downside risk is unlimited. Which means that the more price hikes, the more sellers lose.

Sell Put

When traders Sell Put options, they expect that the price will remain the same or rise. Sell Put is similar to Sell Call but reversed. Sell Put seller has the obligation to buy until the expiry date arrives. Which makes profits limited and risks potentially unlimited. The more price drops, the more investor losses.

What to do when you are expecting underline price rise/fall

In general, selling means that you are predicting prices to drop and position yourself to make profits or get out of an active position. In options trading, selling doesn’t always mean going bearish. And that confuses people.

In options trading, selling a call option and buying a put option are both bearish strategies. On the other side, buying a call option and selling a put option are both bullish strategies.

Why do forex traders favor options?

Options are very popular among forex and stock traders, as they allow for fast, flexible trading strategies with no obligation to deliver the underlying asset. Here are some of the reasons why many traders choose to incorporate options into their strategies:

• Options are cost-effective – Options give traders access to significant amount of leverage, which is especially true for forex options, which makes them highly favorable for traders with limited budgets and high-frequency trading strategies
• Forex options have much higher potential returns than spot trading, which has notoriously tight profit margins
• Options can be used to hedge risks against existing positions and their inherent risk is limited to the premium paid when buying
• Traders can build complex strategies that involve put and call options with different strike prices and expirations dates that can be significantly profitable

Limitations of forex options trading

• Options contracts are known to have higher commission charges than other asset classes
• Forex options are less liquid than the underlying pairs, which can make them highly volatile
• Options lose value as they get closer to expiration, regardless of how well the underlying pair performs
• Not all pairs may have a wide range of options available, which can make hedging against existing positions difficult

Vanilla vs SPOT forex options – what’s the difference?

Traders can choose between two types of options contracts – the traditional vanilla option and the SPOT, or binary option. These two options are not similarly structured and are characterized by differences in volatility, trading strategy, pricing, etc.

Vanilla forex option

A traditional, or vanilla forex option allows traders to buy and sell put and call options on the underlying pair. This gives the contract holder the right, but not the obligation, to buy or sell the underlying asset at the predetermined price upon the expiration of the contract.

The buyer chooses how much to buy, at what price and expiration date, while the seller quotes the premium payable to acquire such options. If a vanilla option expires out of the money, it will become worthless.

SPOT forex option

SPOT, or single payment option trading, is a more flexible variant of an option contract. SPOT options are binary in nature and are all-or-nothing in execution. If a trader sets a trade with specific conditions for the expiration date and these conditions are not met, the option will expire worthlessly and the premium paid for the option will be lost. SPOT options can range from simple binary options to complex specialized structures, which charge higher premiums. The zero-sum nature and all-or-nothing features of SPOT options makes them highly risky and considerably more volatile than their vanilla counterparts.

Example of forex option trading

To better understand the characteristics of vanilla and SPOT forex options, consider the examples of an average trade on each market.

Vanilla

A bullish GBP trader expects the pound to increase in value against the dollar so they purchase a call option with a strike price of $117. The spot rate for the pound was $112 at the time of purchase.

The spot price at expiration was $120. Assuming the contract expired in the money, the profit from the position would be (100*($120 – $117)) = $300. Net profit can be calculated after deducting the premium from the $300 dollar gross profit from the position.

SPOT

Let’s assume a bearish GBP trader expects the pound to drop against the US dollar. The hypothetical price of the pair was $1.1530 and the trader buys 20 options for the pair to reach $1.1350 within 5 days at a quoted price of 52/55, costing $1,100 in total. Assuming there are no commissions, and the pair reaches $1.1280, the binary option would settle at 100 and give a $2,000 payout. The gross gain from the position would be $900. However, if the trade had not reached the strike price of $1.1350, the contract would expire worthless and the trader would lose $1,100.

Exotic forex options

Vanilla and binary are far from the only types of options contracts available to forex traders. Exotic options are options with modified conditions and are typically more complex than regular vanilla and SPOT options.

Pros and cons of exotic forex options

Pros:

• Many exotic options have customizable conditions and are geared towards traders with specific requirements
• Some exotic options have lower premiums than vanilla and binary options
• Exotic options are useful tools in hedging risks from existing positions

Cons:

• Exotic options can be complex with multiple variable conditions that need to be met
• The prices of some exotic options are considerably more volatile than traditional ones
• Exotics with more advanced features can be more expensive than vanilla options

Chooser option

The strike and expiration prices are the same with chooser options, which, as the name suggests, allow traders to choose whether the option is a call or a put at a specific point in time. These options are often deployed when traders are expecting a spike in volatility caused by major news on the market. For example, forex traders can use chooser options during inflationary periods when they are expecting interest rate changes affecting certain currencies. However, these options are more popular with stock traders prior to earnings calls and product launches.

Compound option

Compound options replace the underlying asset with another option contract. In other words, compound option is an option on an option.

This means that the compound option depends on the price movement of the underlying option, which is also dependent on the underlying currency pair performance.

These options are useful in mitigating the downside of an existing options contract that may miss the strike price and expire worthlessly or simply hedge against the risk of any existing option position.

Barrier option

Barrier options are somewhat similar to vanilla options, with the difference being that they only activate once a predetermined price point has been reached. These options have knock in and knock out prices that determine whether they are in the money or out of the money, thus, the price of these options move frantically unlike vanilla options.

Four types of barrier options are available on the market:

• Up-and-in – activates the option once price rises to a specific point
• Up-and-out – the option gets knocked out once price rises to specific point
• Down-and-in – activates the option once price drops to a specific point
• Down-and-out – the option gets knocked out once price drops to a specific point

Quanto-option

Quantity-adjusting options or Quanto-options are options that allow traders to gain exposure to a foreign asset at a fixed exchange rate so this exposure and foreign exchange risk does not make trading the asset redundant. Trades in assets with a limited profit margin can have their profits wiped out by converting local currency to the currency traders are gaining exposure to.

Traders can use quanto-options to gain exposure to foreign indices at a fixed rate without having to convert their capital and incur potential exchange rate loss.

Look-back option

Look-back options are options contracts that let traders choose the best possible exercise price for their trades. This eliminates the risks associated with timing market entry. Exercise prices are not predetermined and are set at the expiration date. The most favorable price point during the life cycle of the contract will be picked at expiration. This favorable exercise price strategy also makes look-back options more expensive than vanilla options.

Main takeaways from forex option trading

• Forex options are securities that enable traders to take positions on the future price direction of currency pairs
• Options are frequently used for their versatility and convenience in hedging against existing positions
• Options have strike prices that need to be met before expiration, or they will expire worthless
• There are two main types of options on the market – vanilla and SPOT (binary)
• Option buyers only risk to lose the amount paid as premium and have unlimited upside potential. On the other hand, Options sellers have limited rewards and unlimited risks
• Exotic options are a subset of options contracts that offer customizable terms to traders and can be more complex than vanilla and binary options

FAQs on forex option trading

Can I do option trading in forex?

Options are contract types that cover a large number of assets, including Forex. You can choose between Forex options, spot currency trading and Forex forwards. However, not all brokers are offering trading various asset classes to their clients.

How does the FX option work?

Forex options give traders the opportunity to buy a call or put option to speculate on the price direction of an underlying currency at a specific point in time. Buying a call option and selling a put option both mean that a trader is expecting the price of the underlying asset to rise and positions trade accordingly. While, selling a call option and buying a put option are both placed when the trader expects a price drop.

Are forex options safe?

While forex options are less regulated than stock options, trading certain types of options limits the downside risk to the exact amount of premium paid.

What are vanilla forex options?

Vanilla options refer to the put and call options available for traders that allow them to buy and sell options on an underlying currency to speculate on the direction of its price at a predefined expiration date. If the strike price is not met by expiration date, the option will expire worthless.

What are exotic options in forex?

Exotic options in forex are options that differ by expiration date, strike price and payment structure from the typical vanilla option contracts. There are various types of exotic options available for traders.