Trading Options on Currency
Trading options on currency is a common means of hedging risk in international business transactions. Trading options on currency works the same as stock options trading and trading options on commodities. A trader buys calls or puts on one currency with another. But, in the case of trading options on currency, both sides of the trade are currencies. If you buy a call on US dollars with Euros it works out the same as buying puts on Euros with US dollars. As with all options trading buying a call contract gives the buyer the right to purchase at the strike price throughout the duration of the options contract. The buyer pays a premium for this right and is under no obligation to execute the contract. Likewise with a put contract the buyer can sell at the strike price throughout the duration of the contract but is under no obligation to do so. Trading options on currency helps traders hedge currency risk and allows them to leverage their trading capital.
Selling Currency Options Entails Risk
Buyers of calls or puts on Forex contracts pay a premium which is the limit of their risk. Sellers gain a premium but accept virtually unlimited risk. Over time sellers tend to make more money than buyers. However, the possibility of huge losses typically limits selling currency options to large investment banks and traders with substantial capital reserves.
Volume, Volatility and Profits
Major Forex currencies trade in high volume and occasionally with a great deal of volatility. High options trading volume makes technical analysis of trades more accurate and potentially more profitable. High options volatility can lead to more risk for sellers but also higher profits for buyers. The point of buying options in a volatile market is that buyers have limited risk and can take advantage of big swings in the market. Sellers hope for tranquil markets and routine profits.
Profit from the Value of the Options Contract
Most traders do not wait for their options contracts to expire. Rather they enter into a contract in search of short term profits. They do so by both fundamental and technical analysis of the currencies which underlie the trade. When currency prices move as anticipated the value of their options contract goes up and they can sell the call or put contract and pocket the profits. An options buyer does not need to invest any more money in this transaction than the premium. Thus a trader can gain a multiple of what he invests in a trade and then move on to the next.
Forex markets were invented to facilitate international trade. When someone buys a product from another country he typically needs to pay in the currency of that nation. Trading options on currency is a way to avoid losing money in foreign transactions. As an example XYZ Corp. in Japan buys products from ABC Industries of Great Britain. They sign a contract and wait for the products to arrive. When they receive shipment they must convert Yen to Pounds and pay the bill. But what happens if the value of the Pound goes up versus the Yen between the time that the contract is signed and when payment is due. By trading options on currency the Japanese company can lock in the price that they will pay for Pounds in the case that the Pound goes up in value. They will buy calls on the Pound with the Yen. If the Pound goes up they will exercise the contract. If the Pound falls in value they will simply let the contract expire and make payment with fewer Yen than expected.