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FX Options 1.1 Introduction

When we trade FX "spot" we buy one currency and simultaneously sell another at whatever the market price is at that time. Spot refers to the current price. If the currency we bought rises in value against the currency we sold, we make money - and conversely, if the value falls, we lose money.

An Option, on the other hand, is about trading the currency pair in the future and only if the price is in our favor – at that time. It’s the possibility of trading the currency pair in the future at a predefined price, but is not an obligation to do so.

The basic and most common options type is called a ‘vanilla option’. And there are two types of vanilla options – Call options and Put options.

A Call option is the right to buy a currency pair at a certain date in the future - referred to as the ‘expiry date’ of the option - and at a certain price. This is known as the ‘strike price’ of the option.

Buying a Put on the other hand gives you the right to sell the underlying currency pair at the strike price on the expiry date.

FX Options are very flexible. You can choose exactly which strike fits your strategy and how long you want the option to last.

The combination of different strikes and expiry dates will determine the price, or premium, of the option. In other words, the price you have to pay in order to "take" the Option. 

Table of contents

What is a Call Option?

A Call option is a "contract" which allows the investor to buy a specific amount of the underlying currency pair at the time that the option expires. The maturity of the option and the strike price are predefined and both of these parameters impact on the price. The option to buy the underlying currency pair is exactly what it sounds like… an "option". It is not something you are obliged to do.

If the underlying currency pair are trading above the strike price at the end of the option contract, then the investor can use the right and exercise the option to buy the currency pair at the strike price.

If the underlying spot price doesn’t reach that level and continues to trade below the strike price, then the investor can simply choose to let the option expire, without doing anything.

This basically means that the investor gets the upside potential on a trade without the downside risk.

An example of a Call option in relation to a Euro dollar trade

We’re Looking at Euro Dollar spot, currently trading at 1.1000. We expect the currency pair to trade higher over the next two weeks and therefore set a target at 1.1300.

Call Option

To express our market view, we buy a Euro Dollar call option with a strike at 1.1050 and an expiry date in 2 weeks time. The price of the option is 50 pips. So, if we buy this option for a notional value of 10,000 Euro Dollar, then the premium of the option will be:

10,000 x 0.0050 which equals 50 Dollars.

If, after 2 weeks, Euro Dollar is trading below 1.1050, then we will let the option expire. There’s no point in buying Euro Dollar spot at 1.1050 when we can buy it cheaper in the market. The premium we paid for the option will be lost. Notice that the premium is the maximum amount you can lose when buying an option.

On the other hand, if Euro Dollar trades above 1.1050 then we should exercise the option, but we need it to trade above 1.1100 to make a profit on the strategy. This is because the price of the option was 50 pips.

Call Option EURUSD Chart

With Euro Dollar reaching our target at 1.1300 after 2 weeks, we can exercise the option and buy Euro Dollar spot at 1.1050. This will give us a profit of 250 pips on the option, minus the 50 pips we paid in premium, so 200 pips.

So, investing in Euro Dollar via FX Options guaranteed a maximum loss of 50 pips, but had a potentially unlimited upside.

What is a Put Option?

A Put option is a contract that allows the investor to sell the underlying currency pair at the strike price when the option expires. So this is the exact opposite of a call option - this is an option to sell the currency pair and not the obligation.

Put options can therefore be applied to express the view that a specific currency pair will trade lower.

And again, the maximum loss on the option is the premium paid. The potential profit on the other hand is unlimited.Let’s take a look at an example.

An example of a Put option using ozzy dollar as an illustration

We think AUSUSD is overvalued and would like to express this in our portfolio.

Well, we could sell AUSUSD spot – this means we sell at the current market price. The only problem is that it leaves us with open risk on the upside. Most traders have been in a situation where their “stop loss” level has been hit due to temporary volatility, only to see a correction in the market back towards your target. The right view of the market, but a loss instead of a profit.

So, instead we buy an Option.

AUSUSD is currently trading at 0.7500. We target a move to 0.7000 within 2 months.

We buy an AUSUSD put strike 0.7300, expiring in 2 months. The cost is 100 pips.

Put Option

During the 2 months we don’t have to worry about a stop level. At any spot level above 0.7300 we can just let the option expire which leaves without a position. The max loss is capped at 100 pips.

Should ozzy dollar reach our target after 2 months, we can then exercise the option and sell at 0.7300. The strategy will earn us 300 pips, minus the 100 pips we paid for the option.

Put Option AUDUSD chart

The Profit / Loss chart clearly shows the advantages of using FX Option. Max loss is limited, so we don’t need a stop on our position. And at the same time the potential profits are unlimited.

Important! In previous examples we took a look only at buying separate Call or Put options. Trading complicated Fx options strategies you may open multiple long or short positions, therefore your risk will become unlimited. In this situation you may subsequently be called upon to pay margin on the option up to the level of your premium. If you fail to do so as required, your position may be closed or liquidated.

If you write an option, the risk involved is considerably higher than buying an option. You may be liable for margin to maintain your position and a loss may be sustained well in excess of the premium received.

By writing an option, you accept a legal obligation to purchase or sell the underlying asset if the option is exercised against you. It does not matter how far the market price has moved away from the strike. If you already own the underlying asset that you have contracted to sell, your risk will be limited.

If you do not own the underlying asset (an “uncovered call option”) the risk can be unlimited. Only experienced persons should contemplate writing uncovered options, then only after securing full detailed of the applicable conditions and potential risk exposure.