FOREX BLOG

Almost all traders try to look for suitable investment vehicles to diversify and optimize their portfolio in order to get profit and limit risks in currency trading. Among numerous financial products, trade forex options is a top choice for most traders for it is well known for its high liquidity, high flexibility, high leverage etc. For novice traders who want to trade successfully in the forex market, they need to know things about trade forex options in order to use them in currency trading and enjoy higher profit potential.

What is forex options trading?

First of all, traders need to know the definition of forex options. In general, forex options are a kind of financial derivatives that offer traders the right but not the obligation to trade a currency pair at a pre-determined forex rate on a specific date. From the definition, we can see that trade forex options enables traders to hedge their risks and even make profits from it. Normally, traders would have their prediction of the future forex market and make bets on how the currency value changes in future. If the price change meets their expectation before the expiration date, then traders can make profits from it. If traders lose, the only losses they need to suffer are the premium, which is quite beneficial to traders.

Why trade forex options?

Forex options are traded for two purposes: hedging and speculation. As for hedging, traders hedge against their positions by trading with forex options together with stop loss order etc. with the expectation to limit the potential risks. Therefore, if the price continues to move against their existing position before the expiry date, traders can still benefit from their forex options for they can be used to hedge against the risk. Nowadays, a great number of traders trade forex options to make profits or speculate in the forex market.

How to trade forex options?

In order to limit potential losses and get profit, traders need to know how to trade forex options. For example, if traders predict that the value of a currency is going to rise in the near future, they can go long some call forex options in order to limit the potential risks; conversely, if he forecasts that the value of a currency will depreciate in the near future, and then he can choose to trade put forex options instead. Moreover, traders are able to trade forex options in forex news trading for the market tends to be quite volatile during news release and traders are possible to hedge against the risks and make profit by combining forex options and news.

As traders are getting sophisticated, they consider to trade forex options as a forex trading technique to see the options of making a profit in the market. How to trade forex options to advance your forex trading techniques?

How to trade forex options?

Forex options are a type of forex derivatives with the underlying asset being currencies. In other words, when you trade forex options, you are merely trading a derivative of the currency pairs, since forex options do not refer to under concrete stuff by itself.

Typically you can trade forex options in four different ways

Trade forex options – buy a call

Trade forex options – buy a put

Trade forex options – sell a call

Trade forex options – sell a put

So the key to understand how to trade forex options is to understand what is a call option and what is a put option.

A call option is an insurance that guarantees you that you can buy the specific currency pair at a predetermined price at the specific time. A call option is an insurance that guarantees that you can sell a currency pair at a pre-determined price at a specific time in future. So when you buy an option, you buy the insurance for safety in future; when you sell an option, you are like the insurance company that guarantees the buyer that you will provide them the chance to make the trade at a future time.

The tricky part to trade forex options is to figure out what kind of protection you want to get or what kind of protection you want to give to other people. When you offer protection, you get some protection fees and when you need protection, you provide some protection fees.

Why to trade forex options can give you an edge?

For example, you believe that the currency pair EURUSD, 1.2998, currently stands on the top of the trend may soon reverse and take a downward trend. To minimize your loss if you are wrong, you place a stop loss order on 1.3200, which is almost 200 pips before you get stopped out. On the other hand, you think once the stop loss is triggered, your loss of 200 pips is very painful. Therefore, you seek to trade forex options to give you some extra protection.

Here, you try to trade forex options, the option on EURUSD, for protection. Therefore you should buy the option instead of selling it. Since you are afraid the market may go up instead of falling down, you buy the call option with a strike price of 1.3000. If the market does go down and you are right about the market initially, you don’t have exercise the option; if the market however bounces up and the stop loss is triggered, you will can buy the currency pair at 1.3000 and sell it at 1.3200 or higher to make it even. By doing this, it’s only the protection or insurance fee and transaction cost you lost in the trade.

Many traders, eager to get to the strategies that they believe will provide quick profits in forex option trading, look for an easy way to trade that does not require that much thinking. But in fact, more thinking and less trading can often save a lot of unnecessary pain. That is to say, to do forex option well, traders have to know every single detail of what they are doing well. For example, they need to fully understand Forex option volatility for the average forex option trader. They need to know all the essential elements for a solid understanding of both the risks and potential rewards related to Forex option volatility that await the trader who is willing and able to put them to good use.

Volatility changes can have a potential impact – good or bad – on any Forex trade you are preparing to implement. Perhaps the most practical aspect of a volatility perspective on Forex option strategies and option prices is the opportunity it affords you to determine relative valuation of options. Due to the nature of markets, Forex option may often change in price in events that are expected. Therefore, when looking at forex option prices and considering certain strategies, knowing whether options are “expensive” or “cheap” can provide very useful information about whether you should be selling options or buying them.
An important factor in Forex option volatility theory is in the selection of strategies. Therefore, as implied volatility levels change, there will be an impact on the strategy performance. Clearly, knowing where implied volatility levels are and where they are likely to go once in a trade can make all the difference in the outcome of strategy.

Basic Forex Option Volatility Strategy
When a Forex option position is established, net buying or selling, the volatility dimension often gets overlooked by inexperienced traders, largely due to lack of understanding. For traders to get a handle on the relationship of volatility to most options strategies, first it is necessary to explain the concept known as Vega.
Like Delta, which measures the sensitivity of an option to changes in the underlying price, Vega is a risk measure of the sensitivity of an option price to changes in volatility. Since both can be working at the same time, the two can have a combined impact that works counter to each or in concert. Therefore, to fully understand what you might be getting into when establishing an option position, both a Delta and Vega assessment are required.

Forex Option Strategy: Vega

Vega tells us about the risk from the perspective of volatility. Traders refer to Forex option positions as either “long” volatility or “short” volatility. The terms long and short here refer to the same relationship pattern when speaking of being long or short a stock or an option. That is, if volatility rises and you are short volatility, you will experience losses, and if volatility falls, you will have immediate unrealized gains. Likewise, if you are long volatility when implied volatility rises, you will experience unrealized gains, while if it falls, losses will be the result.
Beginning with simply buying calls and puts, the Vega dimension can be illuminated. Figures 9 and 10 provide a summary of the Vega sign (negative for short volatility and positive for long volatility) for all outright options positions and many complex strategies.

If volatility declines, prices should be lower. When you own a call or a put (meaning you bought the option) and volatility declines, the price of the Forex option will decline. On the other hand, short call and short put traders would experience a gain from the decline in volatility. Forex options volatility will have an immediate impact, and the size of the price decline or gains will depend on the size of Vega.