Be the first to like this
What are the advantages of trading a Forex option instead of directly trading a currency? In general, option trading helps to hedge risk and also gives the trader a degree of leverage not available when buying or selling currencies.
Hedging Risk with a Forex Option
When a trader expects a currency to go up he can buy it or he can buy calls on it. If he expects it to go down he can buy puts. When buying a currency the trader takes a risk that his analysis will backfire and that he will lose money. If he buys a Forex option he limits his risk to the cost of the options contract, the premium. A Forex option can be a great idea in either a rising or falling market as it helps the trader retain the possibility for a profit while limiting his risk. An options trader or an investor does not need to limit his trading and only use single options to hedge risk. Options traders often use a variety of put and call combinations in order to profit from anticipate movement of currencies while avoiding undue risk. Traders can also guarantee profits no matter which direction a stock moves in price. For example, a long straddle options strategy involves buying both a put and a call on a currency with the same expiration date. The cost is the price of the put and the call. The trader can profit if the currency goes up or goes down. Only if the currency does not move in price does he lose the price of the premiums paid.
Forex Option Leverage
When a trader stakes out a medium term position in a currency he needs to buy a currency and hold until an expected market change occurs. Doing this ties up capital that can often be put to better use elsewhere. When a trader buys a call or put on one currency with the other his investment is the cost of the Forex option. This limits his risk as it is the most that he can lose if the trade goes badly. Let us say that the trade is for $100,000 in the purchase of Euros. The trader buys Euros and waits and the Euro pops up five percent versus the dollar. He makes a five percent profit. But, if he gets a one cent on the dollar call option that costs him $1,000 he makes $5,000 minus $1,000 = $4,000 which is a fourfold or four hundred percent profit. This the attraction of Forex option leverage.