Moving Forward with Currency Options
There are two terms to understand up front before discussing currency options.
- Spot transactions are those where traders establish a currency exchange rate and then make a trade using that rate
- Forward transactions refer to those where currencies will be bought or sold in the future
The FOREX exchange is where currency options are traded. This is the only financial market that operates 24 hours a day on a global scale. FOREX stands for Foreign Exchange and options were added to this market to add some variety to trading opportunities. But unlike a stock option trade or a commodity option trade, the FOREX options must necessarily always involve two financial assets which are two currencies.
When you buy a FOREX option, you are buying the right to buy one currency and sell another. That is how the currency exchange system works. You exchange one currency for another with the intent of making money based on the currency values.
The FOREX currency options are forward transactions because the option holder buys the right to buy or sell a set of specified currencies up to a specified date for a specified price. The strike price in this trading is the specified price as defined in the option contract. If the option is exercised, the currencies are exchanged at the strike price. Just like with all other options, the option holder can let the option expire.
FOREX is an over the counter market so the option terms are not specified in advance. You can indicate the option terms you are looking for and then ask for a price. The price is the premium you pay to buy the option. In this case, the option can be American style or European style which is not surprising considering it’s a globally traded market.
Usually it is the large commercial and institutional investors who take advantage of the customized currency options. There is also another type of option that is used by smaller or individual investors. The second type of option is named SPOT. SPOT is an acronym for single-payment options trading.
The SPOT currency options trading, as defined earlier, is an agreement where two traders establish “bets” on whether two currencies will reach a particular exchange rate. If the exchange rate is reached, a trade will occur if the option is exercised.
- Price may hit a specific spot (one-touch SPOT)
- Price is never reached (No-touch SPOT)
- Price goes above or below a spot price (Digital SPOT)
- Price hits one of two prices that were specified (Double one-touch SPOT)
- Price does not hits one of two prices that were specified (Double no-touch SPOT)
These are merely strategies for hedging bets against the many unknowns that can affect currency rates. For example, war and drought and political unrest can affect currency values. Other risks include interest rate changes, market risk, regulation changes, inflation and many others.
Currency options trading is high risk in general because so many factors can cause currency values to change. The trading uses the same two types of options though: calls and puts. A call option is an option where the buyer has agreed to buy currency at the specified future price. The put option is an option where the option owner has an option to sell currency for a specified price in the future.
Learn all the tips and tricks about currency option – http://www.theoptions.net
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