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Trading FX Options

One of the most common reasons for using FX options is for short-term hedges of spot FX or foreign stock market positions. Learn more.

An FX option (foreign exchange option or currency option) is a financial derivative that gives you the right (but not the obligation) to buy or sell a currency pair at a specific price (called the strike price) on a specific date. (called the date of expiry).

Options contracts are similar to both futures and forwards trading, but when these contracts are put together, they are obligated to execute for their entire term. A call option gives you the right to buy; a put option gives you the right to sell.

For the most part, FX options are essentially the same that drive the underlying currency pair, such as interest rates, inflation expectations, geopolitics and macroeconomic data such as unemployment, GDP, and consumer and business confidence surveys.

There are two styles of options: European and American. European options can only be exercised on the expiration date. American options can be exercised at the strike price at any time before maturity.

How are forex options traded?

Forex option traders use the "Greek" (delta, gamma, theta, rio, vega) to determine option price risk and reward, similar to stock options.

The risk for an option buyer is limited to the cost of buying the option, called the 'premium'. An option buyer has theoretically unlimited profit potential. Conversely, for an option seller, the risk is potentially unlimited, but the profit is fixed at the premium received.

Access to FX options

FX option contracts are typically traded in the over-the-counter (OTC) market, so they are fully customizable and can expire anytime. When you buy a 'call' in the spot options market, you also buy a 'put'. For example, a trader may buy an option in which he is entitled to buy 1 lot of EUR/USD at 1.00 (or face value) within 3 months. This is the "EUR call/USD put".

FX options are also available through regulated exchanges that are options on FX futures. In this case, it's just a call or put. They offer a multitude of expiration dates and quote options on standardized maturities. Forex options are typically available in 10 currency pairs, including the US dollar, and cash settled in dollars when traded on exchanges.

Why trade FX options

One of the most common reasons to use FX options is to hedge short-term spot FX or foreign stock market positions. For example, if you bought the EUR/USD but thought it might go down in the short term, you could buy a EUR put option to profit from the decline while maintaining your buy. You could also sell EUR/USD short at the same time as buying.

Many bullish, bearish and even neutral strategies can be implemented using options contracts.

FX options can be bought and sold. The option price is derived from the base currency, which is the first currency in the currency pair (e.g. EUR to EUR/USD). If you are bullish on the base currency, you should buy a call or sell a put; if you are bearish, you should buy a put or sell a call.

Source: CMC Markets UK

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