How option trading works! When the term “option trading” comes in a discussion, the immediate reaction is to assume the stock market. This is no surprise; options have been a main staple of stock trading for many years. However, since the forex market became widely available by trading via online brokers, option trading in the forex market has become just as popular. The forex option market is the largest, deepest, and most liquid of any option trading market in the entire world. Also, in the hands of a skilled money manager, forex option trading creates more opportunities of limiting losses and increasing profits than in trading currency alone.
In the world of forex option trading, there are usually two routes to take; traditional options (call/put) and SPOT (single payment option trading). Traditional option trading affords the trader the right (but not obligation) to purchase currency at a set time and price. This type of option trading is more closely related to the stock market, and is something many investors can already identify with.
How Option Trading Works
For example, an investor may enter into an agreement (option) to buy a lot of GBP/USD in four months time at a rate of 1.9500. If in 4 months time the price is below 1.9500, the investor considers the option worthless and loses only the premium that was initially put up for the option. If the price shoots to 1.9700 in 4 months’ time, however, the investor would exercise his right to purchase one lot at 1.9500 and immediately sell the lot at market price for 1.9700, creating 200 pips profit instantly.
SPOT (single payment option trading) is generally known as the more flexible method when option trading, and affords the investor many different opportunities. SPOT options work in much the same manner as traditional options do; a contract is entered to buy a specific currency at a specific rate in a specific timeframe. The single main difference is that in SPOT option trading, your option is converted to cash in the event that your option trade was successful. Also, many different scenarios are available for SPOT option trading:
- One-touch SPOT – Option exercised as soon as price hits a predefined level
- No-touch SPOT – Option exercised if a predefined level is not reached
- Digital SPOT – Option exercised if price is between two price levels
This affords the trader many opportunities to achieve exactly the scenario that is predicted. However, the SPOT type of option trading usually has a higher premium; the SPOT option will cost more on average than the traditional option would.
Though it seems that there is a great deal of advantages to forex option trading, there are a few downsides to them as well. The premium (price that the option costs the investor) varies according to the date of the option, the method, and the price in which your option can be exercised, so it is sometimes difficult to keep a specific risk to reward ratio.
Also, in option trading, it may be difficult to point the exact time and price to be profitable due to the longer term that an option is held, and the unpredictability of the currency market. Trends may change from a once lucrative option, and could easily turn a once thought profitable trade into a loss. This isn’t the greatest news for those interested in SPOT option trading, as once you enter into an option, it cannot be sold or traded.
Option trading in the forex market, as well as option trading in any market, can be a very lucrative investment for those with accurate prediction systems. Large sums of money can be pulled out of the market almost instantly after an option is exercised, considering the market being traded is the most liquid market in the world. This is more than enough to make even the most experienced traders across a broad range of markets drool.
These same salivating professionals will still tell you, however, that great care and planning must go into each option trade, as risk of losing a great deal of money is still very real. Any and all investment opportunities should be approached with careful planning; solid money management and prediction systems are the keys, and could very well open the door to a new and exciting investment opportunity in option trading.