Forex options trading is now receiving world wide attention with traditional forex currency traders.
The forex market consists of the spot(cash), futures and options market.
Most traders trade the spot (cash) forex market, however growing in popularity and awareness amongst traders is trading fx options by themselves or in addition to the spot market. The FX options market is the most liquid market for options of any kind in the world.
What is a FX Option?
A foreign exchange option also known as a Forex Option or FX option. A FX option is a financial instrument derived from the value of the underlying asset. In the case of FX options the owner has the right but not the obligation to exchange a certain amount of money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.
This is in effect the same as any normal option, which is defined as;
"the right to buy or sell property at an agreed price; the right is purchased and if it is not exercised by a stated date the money is forfeited".
For more details about the difference between a stock option and a forex option go here.
Forex Option Brokers
For a comparison table of the most popular and best forex option brokers visit brainyforex review page here.
Options can be used in a variety of ways, but they are usually used for in two ways for forex options trading: (1) For profit and / or (2) to hedge against existing positions.
Take a closer look at forex option strategies here.
Forex options trading FOR PROFIT
Buyers of options reduce their risk to the cost of the option. This is called the premium. The options buyers profit potential is unlimited. This is a good trading strategy as most traders find it difficult to cut their losing positions. Forex options trading is a great way to limit losses. The buyer of the option (calls or puts) knows the total risk before the trade is made. [Note that this does not apply to sellers of options, whom receive money upfront for selling options. Sellers should only be experienced traders with years of experience as there exits unlimited risk]. [Remain a buyer of puts and calls and your risk will always remain limited to the purchase price of the option].
Options are also cheaper than the cash forex market. When important economic reports or events are due spreads and risk increase in the cash market. Traders 'in the know' then use forex options trading more heavily.
Forex options trading FOR HEDGING against existing positions.
Some savy traders use forex options in addition to stop loss orders or instead of them. Remember that the options buyer has unlimited profit potential if price continues to move against current position, once their stop is taken out.
Forex options trading mean that current profits in the spot fx market can be locked in once a fx option is bought in the opposite direction. (Should the original position continue in the desired direction, then the option price is viewed as the cost of insurance in case of a reversal).
The difficulties of forex options trading are that premium prices vary according to the strike price and date of the option thereby changing the risk reward ratio.
Apart from the normal options associated with forex options trading there are also other well established exotic options such as the Barrier option and Binary option. The information provided below on these options has been reprinted from www.finotec.com.
Barrier options belong to the category of exotic options – extremely popular among forex option traders – meaning that they possess a component other than the expiry date and the strike price. Regarding barrier options, the additional component is the trigger – or the barrier – which if reached either brings the option into being (knock in option) or cancels it (knock out option). You thus choose a strike price as well as a trigger. Since there is a chance that these options may never come into effect or may be canceled, they are generally cheaper that their vanilla counterpart. Exotic options also include binary options which are based on a hypothetical scenario where you decide how much profit you want to make if the rate reaches a certain level.
A knock-in option becomes a regular option (it is "knocked in”) if and when the trigger price is met before the expiration date. This means that if the rate is never reached, the contract is canceled and the buyer loses the premium. If the barrier rate is met, then the option starts running like a regular put or call option. Knock-in options are less expensive than regular options since they have an additional conditional component that cheapens the price of the premium. The further the barrier to the spot rate, the cheaper the premium, since there is a lesser chance that the option will be knocked in before the expiration date.
The knock out option will automatically cease to exist and expire worthless (it will be "knocked out”) if and when the trigger price is reached before the expiration date. If the rate never hits the barrier, the knock out option runs the same way as a regular option. For a call knock-out option, the trigger is set below the spot rate, and above for a put (out-of-the-money). The higher the implied volatility, the greater the chance the barrier being triggered and the option being knocked out. Knock-out options are cheaper than regular put or call option (vanilla) since they may be knocked out before expiry. The premium gets cheaper as the barrier gets closer to the spot rate since the option has a greater chance of being knocked out.
Reverse knock in
The difference between a knock in option and a reverse knock in option lies in the localization of the trigger barrier. Whereas the trigger is out-of-the money for a knock in, it is in-the-money for a RKI.
Reverse knock out
The difference between a knock out option and a reverse knock out option lies in the localization of the trigger barrier. Whereas with a regular knock out, the trigger is set out-of-the-money (meaning below the spot rate for a call and above for a put), with a RKO, the trigger is set in-the-money (above the spot rate for a call and below for a put).
Binary options are also known as digital options, all or nothing options, fixed rate return options or rebate options. They can be vanilla put and call options conditioned by something else other than just the price and the expiration date. They refer to conditional scenarios that if come true, either validate or invalidate the option. The trader fixes the amount of the desired payout he will get if his conditional scenario proves to be right. The price of the option or premium represents a percentage of that payout.
When buying a one-touch option, traders set that if the currency trades at a specified rate (trigger), then he/she will receive a profit whose amount he has decided upon. He thus knows in advance the extent of his potential profit (payout) and loss (the premium).
When buying this type of option, the trader sets that he/she will make profit (whose amount he/she sets) if and only if a currency rate does not reach the specified trigger before a specified time. The further away the trigger from the spot rate, the lesser payout potential, since there is greater probability that the currency will not touch the strike rate.
Double One Touch
With this type of option, traders choose two triggers and set the profit they will make if either one is hit. Usually, double-one-touch options are used when traders expect highly volatile market conditions but don’t know what direction the market will take. In this sense, double one touch options are similar to long straddle or strangle options.
Double No Touch
Double no touch options are the opposite of the double one-touch options. Traders buy them when they expect a range-bound market with a relatively low volatility. In general, this type of option is profitable during the periods of consolidation that usually follow significant market moves.
Traders often combine various option types to build their option trading strategies. By associating different option types, some traders manage to minimize the risk they are taking. Some even claim to have found infallible methods. Others see it as a simple hedging instrument and use it to secure their funds.
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