Forex Options Basics, Get Started Here
As part of our forex options basics education we present this short course for trading currency options. This course on forex options is geared to traders using plain vanilla puts and calls on the spot forex, but the basic concepts and strategies explained here can be used for other types of options like binary options.
Forex Options Basics, Advantages Of Trading Options
Here is a list of some of the advantages of trading forex options: Protecting profitable spot forex positions for any period of time, preventing losses on spot positions for any period of time, generating extra income on spot forex positions you buy or sell, generating extra income without owning a spot forex position, profiting from forex market movement in either direction when no trend exists, trading with a known or fixed dollar amount at risk and known potential reward every time, making money in a sideways (non- trending) market. There are forex options brokers that offer satisfactory trading platforms for vanilla options like puts and calls, as well as binaries, that can be used with the Forexearlywarning trading system.
Forex Options Basics, Things To Consider
Options are an asset class like stocks, bonds, mutual funds, and commodities. They are in their own asset class. You can buy or sell an option without owning a currency pair.
You can own an option with a currency pair also. With a covered call you have a buy position and a short option position in the same account at the same time. In all of the examples in this forex options basics course we will specify 1 standard lot (10 mini lots) equal to 1 option contract in the examples we use. Traders can trade options on mini lots if they wish. Check with your options broker.
Traders should not be afraid of forex options. Education and demo trading are the keys to using currency options successfully. Traders hear others say that "options are risky," or they hear jargon like “bull put spread” and get scared off. Educate yourself well, and remember that options are for risk reduction; that’s why the professionals use them.
Can Forex Traders Use Options
If you are a spot forex trader and are making consistent pips, you should learn all there is about forex options. If you are still learning to trade the currency market using multiple time frame analysis, currency strength and parallel and inverse analysis, or are just getting started, don’t worry about forex options basics just yet. If you have traded puts and calls in another market like the equity market or index options and you like trading options, then you are also a candidate for trading forex options or possibly binary options trading.
Forex Options Basics, Key Terminology
These are example options transactions for the ten key terms defined below. For these examples and definitions, assume the EUR/USD is currently trading at 1.5500 and use 1 regular lot for the spot position size:
At-the-money - An option contract with a strike price at (or very close to) the underlying rate; also, the closest strike price to the underlying rate. If you purchase 1 call option at 1.5500 you bought a call at-the-money.
Exercise and Assignment - All puts and calls that are in the money are exercised the day of expiration the specified time with a spot position. There is no premature assignment. Out of the money options expire worthless. If an options trader sell a covered call at 1.5500 on the EUR/USD and the price is above 1.5500 at expiration, the spot position will be removed from your account and you will keep the premium.
Hedge - The purchase or sale of options or futures contracts as a temporary substitute for a transaction to be made at a later date. Usually it involves opposite positions in the cash, futures, or options market. If you buy 1 regular lot of the EUR/USD then 1 put option at 1.5500 you have a perfect hedge or married put.
In-the-money - Option contract that has some intrinsic value. If you buy a put option at 1.5500 strike price and the EUR/USD drops, the put goes into the money.
Intrinsic Value - The difference between the strike price and the underlying fx spot contract rate (American Style Options) or the fx forward rate (European Style Options). The intrinsic value represents the actual value of the option if exercised. Please note that the intrinsic value must be zero (0) or above - if an option has no intrinsic value, then the option is simply referred to as having no (or zero) intrinsic value. (The intrinsic value is never represented as a negative number.)
If you buy a put option on the EUR/USD at 1.5500 strike price for a premium of $500 this is all time value and no intrinsic value. If the EUR/USD drops 50 pips and the option is worth $1000, $500 is time value and $500 is intrinsic value (in the money amount).
Option Contract - A financial contract giving the buyer the right, but not the obligation, to purchase or sell a specific forex contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the buyer pays to the seller for the contract rights is called the "premium." This is for someone who buys a put or call.
Option Premium - The amount the buyer pays to the seller for the rights of an option contract.
Out-of-the-money - An option contract having no intrinsic value. EUR/USD trading at 1.5500, buy a put at 1.5500 strike price. The put has no intrinsic value. If the EUR/USD rises above 1.5500 the option is out of the money.
Strike Price – Exercise price.
Uncovered - If you sell a put or call on the EUR/USD with no underlying spot position you are “naked” or uncovered. Don’t do this unless you understand the risk.
Example Forex Options Transaction
In the example below if a forex options trader buys a put on the EUR/USD at a strike price of 1.5500 and the current price is 1.5400 you bought a put in the money since the current market value is below the strike price. If you buy a put on the EUR/USD at a strike price of 1.5500 and the current price is 1.5600 you bought a put out of the money. When you buy a put option you expect the EUR/USD to fall, out of the money options have less expensive up front cost to buy.
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Forex Options Basics, Choosing Expiration
Each time you enter a forex options trade you must choose the expiration time for the option. In the example above, you are buying a put option on the EUR/USD and you expect the EUR/USD to drop in price. If you expect the EUR/USD to drop to the 1.5200 support level, you have a great potential trade, but now you must estimate how long it will take it to get there. If you believe the EUR/USD will drop to 1.5200 in about 3 days, then your expiration time on the put option should be 4 to 5 days. If the EUR/USD drops all the way down to 1.5200 in 2 days this is not a problem at all if your expiration is 4 or 5 days. Demo trading options using various expiration times is a great way to practice, risk free.
Forex Options Basics, Underlying Instruments
An option is a derivative based on an underlying asset. In the case of forex options, a currency pair is always the underlying instrument. The options is priced based on the value of the currency pair for which the put or call option is assigned. There are 28 potential instruments (currency pairs) that can be used for options with our trading system. All 28 pair combinations of the USD, CAD, EUR, GBP, CHF, JPY, AUD, and NZD can be used. For example, traders can have puts or calls assigned to the EUR/USD, AUD/CAD or GBP/CHF, and different prices for each option for different strike prices and expirations.
If a trader needs a trend based trading system to use with spot forex pairs and/or currency options, they should consider the forex trading system from Forexearlywarning.com. We provide trend based trading plans and live signals for all 28 pairs, and the system is currently being used by options traders.