Before you can begin trading currency options you need to understand the basics of how a currency option works. The currency option is the right to exchange two currencies for a predetermined rate at some point in the future. If the exchange rate exceeds the contractual exchange rate before the deadline, you win. If not, the contract expires worthless. The best starting place for currency option trading is to understand why other investors buy and hold different options.
How Investors and Businesses Use Currency Options
Inflation Hedges
Some wealthy investors or companies will use currency option trading to insure against a spike in inflation. If the value of your currency begins to buy less goods then the currency will also be able to purchase less of another currency. Properly designed options on a foreign currency can be arranged so no money is lost in periods of excessive inflation because you make more money from the options than you lose in devaluing of the dollar.
When you read in the news that people are becoming afraid of inflation as a trader you’ll see increased volatility, which is the key to success in option trading. When you buy into a low period of volatility the currency options are priced very low. When volatility increases the pricing skyrockets.
Exchange Rate Protection
When companies do business from other countries they add a level of risk with exchange rate differences. If they are working with the average consumer in the foreign country then they increase their risk even more because they must work with the local currencies and can’t swing the pricing too much. The business may purchase options so they give up a steady small percentage of the exchange, but protect themselves from any large negative changes that are out of their control, like political environments.
As a currency option trader you should be on the lookout for governments threatening to change economic systems and countries that are doing more business with other nations than before. This is where large investors will be purchasing more options and you the trader can move within the price movement.
Reduce Margin Risk
It can be scary for the normal FX investor to leverage 100:1. Owing 100 times what you have is always nerve-wracking. They say the currency market is too large to swing too fast, but “they” aren’t the ones who will go bankrupt if it happens. Some FOREX investors may move to options to get some levels of leverage without owing anything if it turns sour. So following what the regular FOREX traders are doing is helpful for currency options trading.
Dangers of Currency Option Trading
Well, it wouldn’t be fair to ignore the downsides or risks or currency options. There has been plenty of news in the financial market about the dangers of derivatives and this is one of them. Understanding the tradeoffs will give you a more rounded picture of how options can be used in a trading plan.
Increased Trading Costs
The standard FOREX trades have no commissions. The brokers make all of their money off of the spread. Currency options also have a spread, but they also carry a transaction fee per option. The options are traded on different markets than the FOREX. Most are actually traded over the counter (OTC) but the Chicago Board of Exchange (CBOE) also carries some currency options.
Lower Liquidity
We all remember our moms saying, “It’s only worth what someone is willing to pay for it!” when we tried to tell her how much our baseball cards were worth. Options can have the same issue. There isn’t near the volume of the FOREX or even the stock market. Sometimes only a dozen of any give option is being traded on the market. While the pricing may be favorable, if there is no market to sell the option you could be forced to give it away or actually exercise the option. When you exercise the option it could require huge amounts of capital to purchase the currency you were allowed to buy. Then you have to put that currency back on the market to make your profit.
Complicated Pricing Models
There is no way around it, the black-scholes model is really complicated. Add a second interest rate to the model and you get the more complicated Garman-Kohlhagen model. I won’t bother to pretend I understand the entire logic, but essentially the volatility of the rate, two interest rates, time left to expiration, and distance from the strike price all factor into the model. Of course this model is used for calculating new options pricing, but the market determines the real value of the option.
The biggest problem is volatility while there is any time left on the contract. You could have your direction correct, but the price of your option may fall if the volatility falls as the exchange rate climbs towards your strike price. In these cases you’ll be forced to hold the contract all the way to expiration, which is very dangerous for the currency option trader.
No Long Term Trends
The worst part for currency option trading is that there is no long term growth with an exchange rate. The rates are relative to each other and unless a country is in total decline they tend to level out. When you buy options on a stock you know most stocks grow over time and that adds safety to the call buying because if you have time the stock will likely climb.
The exchange rates will most likely stay flat if anything. Without volatility it’s difficult to stock trade. Your trading plan should look for breakouts in exchange volatility as much as breakouts in exchange direction. You should also consider selling options onto the market. This is still option trading you’re just initiating the option and playing the strengths (low volatility) of the currency markets.