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Foreign Exchange Options
A foreign exchange options is another component that draws similarities with the stock market; they offer traders more security in being able to limit risk and increase profit when trading in the market. There are generally two types of foreign exchange options an investor can choose from, the first being a traditional option. This gives the buyer the right but not the obligation to purchase a currency at a set or agreed price and time. If a trader has taken advantage of Foreign exchange options and during the agreed time the currency being bought appreciates, the trader can sell this currency at a profit.
However, if the currency depreciates the trader loses only the premium paid for the option. The second type of foreign exchange options available is known as SPOT- Single Payment Options Trading. The foreign exchange trader dictates this type of option; it is a prediction from the trader on what they forecast will occur on the Foreign exchange market. If the trader is successful the profit potential can be unlimited and if the SPOT is not a success only the premium is lost. Foreign exchange options give investors another tool with which to limit losses and increase profits, they are particularly popular at periods of economic reporting.
Foreign exchange options transactions carry a high degree of risk. Purchasers and sellers of foreign exchange options should familiarize themselves with the type of option (i.e. put or call) which they contemplate trading and the associated risks. You should calculate the extent to which the value of the foreign exchange options must increase for your position to become profitable, taking into account the premium and all transaction costs.
The purchaser of foreign exchange options may offset or exercise the foreign exchange options or allow the foreign exchange options to expire. The exercise of an option results either in a cash settlement or in the purchaser acquiring or delivering the underlying interest. If the option is on a leveraged position, the purchaser will acquire a foreign exchange open position with associated liabilities for margin. If the purchased foreign exchange options expire worthless, you will suffer a total loss of your investment which will consist of the option premium (transaction costs on foreign exchange are usually zero - no commission). If you are contemplating purchasing deep-out-of-the-money foreign exchange options, you should be aware that the chance of such foreign exchange options becoming profitable ordinarily is remote.
Selling ("writing" or "granting") an option generally entails considerably greater risk than purchasing foreign exchange options. Although the premium received by the seller is fixed, the seller may sustain a loss well in excess of that amount. The seller will be liable for additional margin to maintain the position if the market moves unfavourably. The seller will also be exposed to the risk of the purchaser exercising the option and the seller will be obligated to either settle the option in cash or to acquire or deliver the underlying interest.
If the foreign exchange option is on a leveraged position, the seller will acquire an open foreign exchange position with associated liabilities for margin. If the foreign exchange option is "covered" by the seller holding a corresponding position in the underlying interest or a future or another option, the risk may be reduced. If the option is not covered, the risk of loss can be unlimited.
Certain brokers in some jurisdictions permit deferred payment of the option premium, exposing the purchaser to liability for margin payments not exceeding the amount of the premium. The purchaser is still subject to the risk of losing the premium and transaction costs. When the option is exercised or expires, the purchaser is responsible for any unpaid premium outstanding at that time.
Many people think of the stock market when they think of foreign exchange options; however, the foreign exchange (FOREX) market also offers the opportunity to trade these unique derivatives. Foreign exchange options give retail traders many opportunities to limit risk and increase profit. Here we discuss what foreign exchange options are, how they are used, and which strategies you can use to profit.
Types of Foreign Exchange Options There are two primary types of foreign exchange options available to retail foreign exchange traders. The most common is the traditional call/put option, which works much like the respective stock option. The other alternative is single payment option trading --or SPOT-- which gives traders more flexibility.
Traditional Foreign Exchange Options Traditional foreign exchange options allow the buyer the right but not the obligation to purchase something from the option seller at a set price and time. For example, a trader might purchase an option to buy two lots of EUR/USD at 1.3000 in one month; such a contract is known as a "EUR call/USD put." (Keep in mind that, in the foreign exchange options market, when you buy a call, you buy a put simultaneously--just as in the cash market you buy one currency and simultaneously sell another.) If the price of EUR/USD is below 1.3000, the option expires worthless, and the buyer loses only the premium. On the other hand, if EUR/USD skyrockets to 1.4000, then the buyer can exercise the option and gain two lots for only 1.3000, which can then be sold for profit.
Since foreign exchange options are traded over-the-counter (OTC), traders can choose the price and date on which the option is to be valid and then receive a quote stating the premium they must pay to obtain the option.
There are two types of traditional foreign exchange options offered by brokers:
American-style – This type of option can be exercised at any point up until expiration. European-style – This type of option can be exercised only at the time of expiration.
One advantage of traditional foreign exchange options is that they have lower premiums than SPOT foreign exchange options. Also, because (American) traditional foreign exchange options can be bought and sold before expiration, they allow for more flexibility. On the other hand, traditional foreign exchange options are more difficult to set and execute than SPOT foreign exchange options.
Single Payment Options Trading (SPOT) Here is how SPOT foreign exchange options work: the trader inputs a scenario (for example, "EUR/USD will break 1.3000 in 12 days"), obtains a premium (option cost) quote, and then receives a payout if the scenario takes place. Essentially, SPOT automatically converts your option to cash when your option trade is successful, giving you a payout.
Many traders enjoy the additional choices (listed below) that SPOT foreign exchange options give traders. Also, SPOT foreign exchange options are easy to trade: it's a matter of entering the scenario and letting it play out. If you are correct, you receive cash into your account. If you are not correct, your loss is your premium. Another advantage is that SPOT foreign exchange options offer a choice of many different scenarios, allowing the trader to choose exactly what he or she thinks is going to happen.
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There are many advantages to trading spot foreign exchange as opposed to trading stocks and futures.
1. Bid/Ask Spread rates Spread rates have tightened dramatically in the last years. Most online foreign exchange brokers offer a spread of 5 pips on EUR/USD which is currently the most widely traded and liquid currency pair. In the futures market spreads can vary anywhere between 5 and 9 pips and can become even larger under illiquid market conditions (which tends to happen substantially more often in futures currencies).
2. Margins requirements Usually foreign exchange trading with a 1% margin is available. In layman's terms that means a trader can control a position of a value of USD 1'000'000 with a mere USD 10'000 in his account. By comparison, futures margins are not only constantly changing but are also often quite sizeable. Stocks are generally traded on a non-margined basis and when they are, it can be as restrictive as 50% or so. You can start with as little as 25 USD in Easy-Foreign exchange.
3. 24 hour market Foreign exchange market trading occurs over a 24 hour period picking up in Asia around 24:00 CET Sunday evening and coming to an end in the United States on Friday around 23:00 CET. Although ECNs (electronic communications networks) exist for stock markets and futures markets (like Globex) that supply after-hours trading, liquidity is often low and prices offered can often be uncompetitive.
4. No Limit up / limit down Futures markets contain certain constraints that limit the number and type of transactions a trader can make under certain price conditions. When the price of a certain currency rises or falls beyond a certain pre-determined daily level traders are restricted from initiating new positions and are limited only to liquidating existing positions if they so desire. This mechanism is meant to control daily price volatility but in effect since the futures currency market follows the spot market anyway, the following day the futures market may undergo what is called a 'gap' or in other words the futures price will re-adjust to the spot price the next day. In the OTC market no such trading constraints exist permitting the trader to truly implement his trading strategy to the fullest extent. Since a trader can protect his position from large unexpected price movements with stop-loss orders the high volatility in the spot market can be fully controlled.
5. Sell before you buy Equity brokers offer very restrictive short-selling margin requirements to customers. This means that a customer does not possess the liquidity to be able to sell stock before he buys it. Margin-wise, a trader has exactly the same capacity when initiating a selling or buying position in the spot market. In spot trading when you're selling one currency, you're necessarily buying another.
A disadvantage of SPOT foreign exchange options, however, is their higher premiums. On average, SPOT option premiums cost more than standard foreign exchange options.
Why Trade Foreign exchange options? There are several reasons why foreign exchange options in general appeal to many traders:
Foreign exchange options Prices Foreign exchange options have several factors that collectively determine their value:
How It Works – A Scenario. Say it's January 2, 2004, and you think that the EUR/USD (euro vs. dollar) pair, which is at the time at 1.3000, is headed downward due to positive U.S. numbers; however, there are some major reports coming out soon that could cause significant volatility. You suspect this volatility will occur within the next two months, but you don't want to risk a cash position, so you decide to use foreign exchange options.
You then go to your broker and put in a request to buy a EUR put/USD call, commonly referred to as a "EUR put option," set at a strike price of 1.2900 and an expiry of March 2, 2004. The broker informs you that this option will cost 10 pips, so you gladly decide to buy.
This order would look something like this:
Strike price: 1.2900 Expiration: 2 March 2004 Premium: 10 USD pips Cash (spot) reference: 1.3000
Say the new reports come out and the EUR/USD pair falls to 1.2850--you decide to exercise your option, and the result gives you 40 USD pips profit (1.2900 – 1.2850 – 0.0010).
Option Strategies Foreign exchange options can be used in a variety of ways, but they are usually used for one of two purposes: (1) to capture profit or (2) to hedge against existing positions.
Profit Motivated Strategies Foreign exchange options are a good way to profit while keeping the risk down – after all, you can lose no more than the premium! Many foreign exchange traders like to use foreign exchange options around the times of important reports or events, when the spreads and risk increase in the cash foreign exchange markets. Other profit-driven foreign exchange traders simply use foreign exchange options instead of cash because foreign exchange options are cheaper. A foreign exchange options position can make a lot more money than a cash position in the same amount.
Hedging Strategies Foreign exchange options are a great way to hedge against your existing positions to decrease risk. Some traders even use foreign exchange options instead of or together with stop-loss points. The primary advantage of using foreign exchange options together with stops is that you have an unlimited profit potential if the price continues to move against your position.
Hedge ratio An option price does not fluctuate in a one-to-one relationship with the fluctuations in the price of the underlying asset. This is because as the option strike price becomes closer to or further away from the current asset price, the probability of the strike price being in the money changes. In the graph below, you can see the relation of the option price to the underlying asset price. The word used to describe the relationship of the option’s price change to the underlying asset’s price change is the hedge ratio or delta. As you can see, as the option becomes more and more heavily in the money, the option value’s price will fluctuate very closely with the underlying asset price, meaning that the delta is approaching 1. But as the strike price becomes further and further out of the money, the delta approaches zero, as the probability that the option will have any intrinsic value on expiration also approaches zero.
Hedging with foreign exchange options Foreign exchange options are often used in combinational strategies with other foreign exchange options, or as a hedging tool for a spot position. A hedging strategy can be initiated to reduce a potential loss on the investment. If the investor buys a spot position at a price of 100, he has a profit/loss scenario as shown in the left-hand figure below. If the investor buys a put option, he can change the profit/loss scenario and reduce a potential loss. This is illustrated in the right-hand graph below. The advantage of hedging with foreign exchange options instead of using a ”stop” is that you can stay in the market despite movements against your underlying position and still have an unlimited profit scenario. The disadvantage is that you must have a larger gain in the spot before the position makes a profit because you must pay for the option.
Hedging example You speculate that the exchange rate of EUR/JPY will decline steeply in the next week and have the capital to sell 1,000,000 EUR/JPY on margin at the spot price of 105.00. Now you want to protect your position in case of a rise in the EUR/JPY rate.
Protection can be done in two ways 1) you can place a stop order, or 2) buy an option.
1) Placing a stop Let’s say that you consider placing a stop, based on your analysis, at 106.00. Placing a stop order, you will, of course, limit the potential for loss to JPY 1,000,000 (around 9,434 EUR) if the stop (106) is traded, thereby closing your position.
2) Buy an option The other way of protecting yourself from limitless downside in this scenario is with the purchase of a call option. Let’s say that you purchase a one-week call option with the same strike price as the stop-loss order (106.00) at a cost of JPY 300,000 (EUR 2,857). As the holder of this option, you will maintain the potential for unlimited profit because your spot position can stay open until the exercise date without having to worry about losing more than the option premium (JPY 300,000) and the (JPY 1,000,000) loss when the price is at 106.00. The option will protect any final price above that level. That’s because the call option gains value as the spot loses value. In other words, this option scenario can give you a staying power that is not possible with the use of stops. In any market, entering the market several times and hitting multiple stop losses is much more costly than establishing a more strategic foreign exchange options position. This is especially true in cases with high volatility.
The two strategies are shown in the graphic below. The thick blue line shows the profit/loss scenario for the hedged position. Keep in mind that in sideways markets, an option buying strategy can become costly because you are paying for time value that quickly erodes as the expiration date approaches.
Profit and Loss - Hedge Another potential advantage of a hedging strategy is this: in the course of the option’s life, you may reassess your view of the market and wish to actually close the short spot position (even at a loss) in the expectation that the market is going the other way. In this scenario, you close the short position but keep the option, hoping that it will come in the money before expiration. For example, let’s say that after a few days, the spot price for EUR/JPY rises to 105.50 from the entry level of 105.00, and you have changed your mind about the direction of the market. Since you believe the rate will continue to rise, you close your spot position for a loss, but hang on to your option until the expiration. At any level above the break-even point of 106.3 you will begin to make a profit. And again, the option itself might be resold before expiration.
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