Many people think of the stock market when they think of options; however, the foreign exchange (FOREX) market also offers the opportunity to trade these unique derivatives. Options give retail traders many opportunities to limit risk and increase profit. Here we discuss what options are, how they are used, and which strategies you can use to profit.

Types of FOREX Options
There are two primary types of options available to retail FOREX 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 Options
Traditional 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 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 FOREX 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 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 options is that they have lower premiums than SPOT options. Also, because (American) traditional options can be bought and sold before expiration, they allow for more flexibility. On the other hand, traditional options are more difficult to set and execute than SPOT options. (For a detailed introduction to options, see "Options Basics.")

>> Single Payment Options Trading (SPOT)
Here is how SPOT 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 options give traders. Also, SPOT 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 options offer a choice of many different scenarios, allowing the trader to choose exactly what he or she thinks is going to happen.

A disadvantage of SPOT options, however, is their higher premiums. On average, SPOT option premiums cost more than standard options.

Why Trade Options?
There are several reasons why options in general appeal to many traders:

• Your downside risk is limited to the option premium (the amount you paid to purchase the option).
• You have unlimited profit potential.
• You pay less money up front than for a spot (cash) FOREX position.
• You get to set the price and expiration date. (These are not predefined like those of options on futures.)
• Options can be used to hedge against open spot (cash) positions in order to limit risk.
• Without risking a lot of capital, you can use options to trade on predictions of market movements before fundamental events take place (such as economic reports or meetings).
  • SPOT options allow you many choices:
  • Standard options.
  • One-touch SPOT – You receive a payout if the price touches a certain level.
  • No-touch SPOT – You receive a payout if the price doesn't touch a certain level.
  • Digital SPOT – You receive a payout if the price is above or below a certain level.
  • Double one-touch SPOT – You receive a payout if the price touches one of two set levels.
  • Double no-touch SPOT – You receive a payout if the price doesn't touch any of the two set levels.

So, why isn't everyone using options? Well, there also are a few downsides to using them:

• The premium varies according to the strike price and date of the option, so the risk/reward ratio varies.
• SPOT options cannot be traded: once you buy one, you can't change your mind and then sell it.
• It can be hard to predict the exact time period and price at which movements in the market may occur.
• You may be going against the odds.

Options Prices
Options have several factors that collectively determine their value:

• Intrinsic value - This is how much the option would be worth if it were to be exercised right now. The position of the current price in relation to the strike price can be described in one of three ways:
  • "In the money" - This means the strike price is lower than the current market price (for calls).
  • " Out of the money" – This means the strike price is higher than the current market price (for calls).
  • " At the money" – This means the strike price is at the current market price.
• The time value - This represents the uncertainty of the price over time. Generally, the longer the time, the higher premium you pay because the time value is greater.
• Interest rate differential - A change in interest rates affects the relationship between the strike of the option and the current market rate. This effect is often factored into the premium as a function of the time value.
• Volatility - Higher volatility increases the likelihood of the market price hitting the strike price within a limited time period. Volatility is factored into the time value. Typically, more volatile currencies have higher options premiums.

How It Works – A Scenario
Say it's January 2, 2004, and you think that the EUR/USD (euro vs. dollar) pair, which is currently 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 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:
Buy: EUR put/USD call
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
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
Options are a good way to profit while keeping the risk down--after all, you can lose no more than the premium! Many FOREX traders like to use options around the times of important reports or events, when the spreads and risk increase in the cash FOREX markets. Other profit-driven FOREX traders simply use options instead of cash because options are cheaper. An options position can make a lot more money than a cash position in the same amount.

Hedging Strategies
Options are a great way to hedge against your existing positions to decrease risk. Some traders even use options instead of or together with stop-loss points. The primary advantage of using 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 above, 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 options
Options are often used in combinational strategies with other 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 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 EURJPY will decline steeply in the next week and have the capital to sell 1,000,000 EURJPY on margin at the spot price of 105.00. Now you want to protect your position in case of a rise in the EURJPY 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 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 EURJPY 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.