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Forex Options Market Overview

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Forex Tips & Resources

Forex Tips & Resources


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  • 1. The forex options market started as an over-the-counter (OTC) financial vehicle for large banks,financial institutions and large international corporations to hedge against foreign currencyexposure. Like the forex spot market, the forex options market is considered an "interbank"market. However, with the plethora of real-time financial data and forex option trading softwareavailable to most investors through the internet, todays forex option market now includes anincreasingly large number of individuals and corporations who are speculating and/or hedgingforeign currency exposure via telephone or online forex trading platforms.Forex option trading has emerged as an alternative investment vehicle for many traders andinvestors. As an investment tool, forex option trading provides both large and small investors withgreater flexibility when determining the appropriate forex trading and hedging strategies toimplement.Most forex options trading is conducted via telephone as there are only a few forex brokersoffering online forex option trading platforms.Forex Option Defined - A forex option is a financial currency contract giving the forex option buyerthe right, but not the obligation, to purchase or sell a specific forex spot contract (the underlying) ata specific price (the strike price) on or before a specific date (the expiration date). The amount theforex option buyer pays to the forex option seller for the forex option contract rights is called theforex option "premium."The Forex Option Buyer - The buyer, or holder, of a foreign currency option has the choice toeither sell the foreign currency option contract prior to expiration, or he or she can choose to holdthe foreign currency options contract until expiration and exercise his or her right to take a positionin the underlying spot foreign currency. The act of exercising the foreign currency option andtaking the subsequent underlying position in the foreign currency spot market is known as"assignment" or being "assigned" a spot position.The only initial financial obligation of the foreign currency option buyer is to pay the premium to theseller up front when the foreign currency option is initially purchased. Once the premium is paid,the foreign currency option holder has no other financial obligation (no margin is required) until theforeign currency option is either offset or expires.On the expiration date, the call buyer can exercise his or her right to buy the underlying foreigncurrency spot position at the foreign currency options strike price, and a put holder can exercisehis or her right to sell the underlying foreign currency spot position at the foreign currency optionsstrike price. Most foreign currency options are not exercised by the buyer, but instead are offset inthe market before expiration.Foreign currency options expires worthless if, at the time the foreign currency option expires, thestrike price is "out-of-the-money." In simplest terms, a foreign currency option is "out-of-the-money" if the underlying foreign currency spot price is lower than a foreign currency call optionsstrike price, or the underlying foreign currency spot price is higher than a put options strike price.Once a foreign currency option has expired worthless, the foreign currency option contract itselfexpires and neither the buyer nor the seller have any further obligation to the other party.
  • 2. The Forex Option Seller - The foreign currency option seller may also be called the "writer" or"grantor" of a foreign currency option contract. The seller of a foreign currency option iscontractually obligated to take the opposite underlying foreign currency spot position if the buyerexercises his right. In return for the premium paid by the buyer, the seller assumes the risk oftaking a possible adverse position at a later point in time in the foreign currency spot market.Initially, the foreign currency option seller collects the premium paid by the foreign currency optionbuyer (the buyers funds will immediately be transferred into the sellers foreign currency tradingaccount). The foreign currency option seller must have the funds in his or her account to cover theinitial margin requirement. If the markets move in a favorable direction for the seller, the seller willnot have to post any more funds for his foreign currency options other than the initial marginrequirement. However, if the markets move in an unfavorable direction for the foreign currencyoptions seller, the seller may have to post additional funds to his or her foreign currency tradingaccount to keep the balance in the foreign currency trading account above the maintenancemargin requirement.Just like the buyer, the foreign currency option seller has the choice to either offset (buy back) theforeign currency option contract in the options market prior to expiration, or the seller can chooseto hold the foreign currency option contract until expiration. If the foreign currency options sellerholds the contract until expiration, one of two scenarios will occur: (1) the seller will take theopposite underlying foreign currency spot position if the buyer exercises the option or (2) the sellerwill simply let the foreign currency option expire worthless (keeping the entire premium) if thestrike price is out-of-the-money.Please note that "puts" and "calls" are separate foreign currency options contracts and are NOTthe opposite side of the same transaction. For every put buyer there is a put seller, and for everycall buyer there is a call seller. The foreign currency options buyer pays a premium to the foreigncurrency options seller in every option transaction.Forex Call Option - A foreign exchange call option gives the foreign exchange options buyer theright, but not the obligation, to purchase a specific foreign exchange spot contract (the underlying)at a specific price (the strike price) on or before a specific date (the expiration date). The amountthe foreign exchange option buyer pays to the foreign exchange option seller for the foreignexchange option contract rights is called the option "premium."Please note that "puts" and "calls" are separate foreign exchange options contracts and are NOTthe opposite side of the same transaction. For every foreign exchange put buyer there is a foreignexchange put seller, and for every foreign exchange call buyer there is a foreign exchange callseller. The foreign exchange options buyer pays a premium to the foreign exchange options sellerin every option transaction.The Forex Put Option - A foreign exchange put option gives the foreign exchange options buyerthe right, but not the obligation, to sell a specific foreign exchange spot contract (the underlying) ata specific price (the strike price) on or before a specific date (the expiration date). The amount theforeign exchange option buyer pays to the foreign exchange option seller for the foreign exchangeoption contract rights is called the option "premium."
  • 3. Please note that "puts" and "calls" are separate foreign exchange options contracts and are NOTthe opposite side of the same transaction. For every foreign exchange put buyer there is a foreignexchange put seller, and for every foreign exchange call buyer there is a foreign exchange callseller. The foreign exchange options buyer pays a premium to the foreign exchange options sellerin every option transaction.Plain Vanilla Forex Options - Plain vanilla options generally refer to standard put and call optioncontracts traded through an exchange (however, in the case of forex option trading, plain vanillaoptions would refer to the standard, generic forex option contracts that are traded through an over-the-counter (OTC) forex options dealer or clearinghouse). In simplest terms, vanilla forex optionswould be defined as the buying or selling of a standard forex call option contract or a forex putoption contract.Exotic Forex Options - To understand what makes an exotic forex option "exotic," you must firstunderstand what makes a forex option "non-vanilla." Plain vanilla forex options have a definitiveexpiration structure, payout structure and payout amount. Exotic forex option contracts may havea change in one or all of the above features of a vanilla forex option. It is important to note thatexotic options, since they are often tailored to a specifics investors needs by an exotic forexoptions broker, are generally not very liquid, if at all.Intrinsic & Extrinsic Value - The price of an FX option is calculated into two separate parts,the intrinsic value and the extrinsic (time) value.The intrinsic value of an FX option is defined as the difference between the strike price and theunderlying FX spot contract rate (American Style Options) or the FX forward rate (European StyleOptions). The intrinsic value represents the actual value of the FX option if exercised. Pleasenote that the intrinsic value must be zero (0) or above - if an FX option has no intrinsic value, thenthe FX option is simply referred to as having no (or zero) intrinsic value (the intrinsic value is neverrepresented as a negative number). An FX option with no intrinsic value is considered "out-of-the-money," an FX option having intrinsic value is considered "in-the-money," and an FX option with astrike price at, or very close to, the underlying FX spot rate is considered "at-the-money."The extrinsic value of an FX option is commonly referred to as the "time" value and is defined asthe value of an FX option beyond the intrinsic value. A number of factors contribute to thecalculation of the extrinsic value including, but not limited to, the volatility of the two spotcurrencies involved, the time left until expiration, the riskless interest rate of both currencies, thespot price of both currencies and the strike price of the FX option. It is important to note that theextrinsic value of FX options erodes as its expiration nears. An FX option with 60 days left toexpiration will be worth more than the same FX option that has only 30 days left to expiration.Because there is more time for the underlying FX spot price to possibly move in a favorabledirection, FX options sellers demand (and FX options buyers are willing to pay) a larger premiumfor the extra amount of time.Volatility - Volatility is considered the most important factor when pricing forex options and itmeasures movements in the price of the underlying. High volatility increases the probability thatthe forex option could expire in-the-money and increases the risk to the forex option seller who, inturn, can demand a larger premium. An increase in volatility causes an increase in the price ofboth call and put options.
  • 4. Delta - The delta of a forex option is defined as the change in price of a forex option relative to achange in the underlying forex spot rate. A change in a forex options delta can be influenced by achange in the underlying forex spot rate, a change in volatility, a change in the riskless interestrate of the underlying spot currencies or simply by the passage of time (nearing of the expirationdate).The delta must always be calculated in a range of zero to one (0-1.0). Generally, the delta of adeep out-of-the-money forex option will be closer to zero, the delta of an at-the-money forex optionwill be near .5 (the probability of exercise is near 50%) and the delta of deep in-the-money forexoptions will be closer to 1.0. In simplest terms, the closer a forex options strike price is relative tothe underlying spot forex rate, the higher the delta because it is more sensitive to a change in theunderlying rate.==== ====Get More Info .....www.forextradinghelp.org==== ====

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