Forex Options Trading

Trading forex options is not unlike in the stock market. The seller or option writer sells a contract that gives the buyer the right, but not the obligation, to buy a predetermined quantity of a currency at a set price, called the strike price, before a specified expiry date. In exchange, the seller gets a fee or premium for this option.

If the price of the currency meets or exceeds the strike price within the expiry date of the contract, the buyer can execute his option and make a profit from the difference. When this happens, the option is said to be 'in the money'.

Forex option trading can be a good way for a trader to make money off of the currency market without risking a lot of money. It is also a good way to hedge any open trading positions that you have.

There are two basic ways to use forex options trading to your advantage. You can use it to speculate purely for profit or you can use it to hedge other bets you are making on the market. Let's first talk about speculation and then hedging risk.

Speculation is trading for no other reason than for a profit. If that sounds mercenary to you, realize that roughly 80% of traders on the forex market are speculators. Trading options is a cheap and relatively low-risk way to profit in this market.

Don't get me wrong. Any activity in the forex market is risky. But with forex options, you are limiting your risk to just your premium. If you buy an option for a set premium and it never goes in the money, you only lose your premium, no matter how low the price goes.

When your forex indicators tell you there might be an opportunity for a profitable trade, you can go in with an option instead of an open position.  One disadvantage to options trading is that there is a time limit. If your price movement predictions don't happen within your allotted time, you lose your premium. Timing is crucial for options trading.

Hedging is a little trickier than speculating. When you speculate, you are merely predicting if and when a currency will go down or up. In hedging you are offsetting your predicted movement to minimize losses.

How It Works

Let's say that I buy an option that gives me the right to buy 1 lot of USD/CAD at 1.05, and the contract will expire in 30 days. If the USD/CAD goes up to 1.07 before the expiration date, I can execute the contract and buy this currency pair at 1.05. Then I can sell it back to the market for 1.07 making a nice profit.

When buy an option expecting the price to go up, it's called a call option. When you are buying an option expecting the price to go down, you would buy a put option. Profiting off of declining prices is called 'shorting'.

There are two types of options contracts. There is the American style and European style contracts. In the American style, you can execute the contract at any time before the expiry date. In the European style, you are only allowed to execute the contract on the expiry date.