Investing in the forex market is increasingly growing in popularity across the world as investors and speculators look to profit from the volatile currency markets with short term buying and selling of currencies.
As the world’s largest financial market with trillions of dollars of currencies traded each day globally, the FX market is the world’s most liquid financial market. However, with liquidity can come volatility and risks which is why FX Options are a useful addition to any investment strategy.
FX Options offer investors the full benefits of unlimited profits for a limited risk. The flexibility of Options is also one of the many reasons why they are popular. They can be used as a direct investment tool for investing in the underlying market, but they can also be applied as a hedging tool to be used in conjunction with existing positions. This allows investors to tailor the risk profile of their position to match any market view that they might have.
FX Options can also be used to express a view on future volatility. For example, if you believe the FX market is about to move but unsure about the direction, you can structure your portfolio to benefit from a move in either direction.
Furthermore, FX Options allow the ability to leverage your position and therefore significantly increase the profits.
How do FX Options work?
The most traditional way to trade FX is to do so via ‘spot FX’. This is when an investor buys one currency and simultaneously sells another at whatever the market price is at that time. ‘Spot’ refers to the current price. If the currency we bought rises in value against the currency we sold, the investor makes a profit. And conversely, if the value falls, the investor will lose money.
An Option on the other hand is about trading the currency pair in the future and only if the price is in the investor’s favour at that time. It’s the possibility – an ‘Option’ – for trading the currency pair in the future at a predetermined price but it’s not an obligation to do so.
The basic and most common Options type is called a ‘Vanilla’ Option and there are two types of ‘Vanilla’ Options: ‘Call’ Options and ‘Put’ Options.
‘Call’ or ‘Put’?
A ‘Call’ Option is the right to buy a currency pair at a certain date in the future and at a certain price. The date at which you have the right to buy the pair is referred to as the expiry date of the option and the agreed price of the Option is known as the ‘strike’.
If the underlying currency pair are trading above the strike price at the end of the option contract, then the investor can use the right and exercise the option to buy the currency pair at the strike price. If the underlying spot price doesn’t reach that level and continues to trade below the strike price then the investor can simply choose to let the option expire without doing anything. This basically means that the investor gets the upside potential on a trade without downside risk. The only loss they will make is on the premium they paid upfront for the Option.
Buying a ‘Put’ Option on the other hand gives you the right to sell the underlying currency pair at the strike price on the expiry date.
The combination of different strikes and expiry dates will determine the price or premium of the Option.
Options in action
For example, imagine EUR/USD is trading at 1.1000, but you think it will trade higher over the next two weeks, so you buy a ‘Call’ Option at the strike price of 1.1050 with an expiry of two weeks. In this example we can say the price of the option is 50 pips. Therefore, if you buy an option on 100,000 EUR/USD at an option price of 50 pips, then the premium you will pay is $500 (100,000 x 0.0050 = $500).
If after two weeks, EUR/USD is trading below 1.1050, then you may choose to let the option expire. The premium paid for the option ($500) will be lost, however the premium is the maximum you can lose when buying an Option.
On the other hand, if EUR/USD trades above 1.1050, then you may want to exercise the right on the Option to take advantage of the market moving to the upside. However, in order to break even, the price must trade over 1.1100 because of the 50 pip premium paid upfront.
A ‘Put’ Option is the opposite – you have the right to sell the underlying currency at the strike price at maturity or choose to let the option expire. You use a ‘Put’ option to express a view that the currency pair will trade lower. Buying a ‘Put’ Option is a great way to take advantage of a declining market.
The full transparency of risk for FX Options is why they are appealing to cautious investors and those looking to balance other risks in their portfolio.
Mario Camara is head of Saxo Dubai