Have you ever heard of a forex option? Don’t be disheartened if you haven’t, because even some experienced traders somehow end up going their entire careers without fully exploring this type of forex trade.
Mainly this is due to the fact that, until very recently, forex options were mainly used by big companies that had deals in multiple currencies and were seeking to hedge their potential losses and reduce their risks.
On a basic level, understanding forex options themselves is fairly easy. An option is essentially just a contract that allows the holder the right to buy (or in some cases, sell) a particular currency at a pre-agreed price and a pre-agreed time, regardless of what the actual market price may be at that point in time.
Of course, this is an extremely attractive proposal because it means that the holder of the option stands to gain if the price that they agreed to buy or sell a currency at is favorable compared to the market price at the time. As such, it should come as no surprise that there is an upfront cost for options – to make it an attractive proposal for both parties (i.e. the holder and the writer of the option).
In a nutshell, if you’re holding an option to trade US$ for Euros at 1.4 and the current market price is 1.6, then you stand to gain tons! If however the current market price is 1.2 or something then you could simply not exercise the option and all you would have lost is the initial cost.
Generally, the pricing and valuation system of options is pretty complicated, and so it can take time and experience to fully appreciate it. Nowadays though, there is another type of option that has cropped up known as the ‘digital option’, and that is seen to be more accessible by casual traders.
With digital options, you decide whether a given exchange rate is going to move up or down, and also decide what type of payoff you desire. Assuming you think that the Euro (which is trading at 1.44 will move to 1.46 within 4 months, and you decide that you want a payoff of $1,000, you’d then have to see how much an option of that variety would cost.
For now, let’s just say that it would cost $100 – and this would mean that if you’re right, you get $1,000, and if you’re wrong, all you’ve lost is the initial $100 that the option cost.
Fully appreciating the value of options is something that many small-time traders have a tough time with. Frankly, it can be a lot of a headache to manage numerous options in multiple currencies, and so if you’re thinking about starting, just keep it simple for now.
Later on, once you get a better grasp of the ropes, you can move on to bigger and more diverse option investments.