FX Options Tutorial

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Conventional foreign currency trades (also called forex or FX) involves buying currencies using very low margin requirements. This offers large potential profits, but means each trade carries very high risk. Traders purchase FX options to reduce risks for other market positions or as stand-alone trades in which risk is limited to the premium paid for the option. FX options confer the right to buy one currency with another at a stated price for a specific period of time. Since you buy the first currency by selling a second currency, FX options are always simultaneously buy (call) and sell (put) options.

Things You'll Need

  • FX trading account
  • Study the workings of the foreign exchange market before you risk your money. Learn how major economic factors like inflation, trade deficits, and monetary policy affect currency rates. You must also gain an understanding of the "technicals," the short term trading patterns that are essential clues for successful FX trading. It's a good idea to open a practice forex trading account. Many forex brokers offer these accounts free of charge. You use real trading software and market information to learn FX trading "hands-on" without risking real money.

  • Open an account with an authorized forex broker. In the United States, forex brokers are primarily authorized by the National Futures Association and must be in compliance with their business and ethical standards. Make sure the broker you choose offers FX options (not all do). Consider opening a "mini" account that allows you to trade small amounts of currency to start. Regular accounts generally require initial deposits of around $2,000. Mini forex accounts may be opened for $100 or even less.

  • Choose the type of FX option you want. Traditional options allow you to buy one currency of a pair with the other currency of the pair at a guaranteed exchange rate called the strike price until the date the option expires. If the currency exchange rate moves in your favor, you can exercise the option and then sell the currency on the market at a profit. Single payment options trading (SPOT) options work differently. When you buy a SPOT option you propose a scenario. For example, you might predict that euros will move from $1.25 to $1.30 per euro within 2 weeks. If your prediction pans out, you automatically receive a payoff.

  • Enter the currency you want to "go long" on (that is, the one you want the right to purchase) and the second currency (on which you by definition must "go short") of the pair into your trading software to purchase a traditional FX option. Ten enter the strike price and expiration date you want. The system will provide you with a premium quote (the price of the proposed option). If it's satisfactory all you have to do is accept the offered premium price.

  • Monitor currency rate changes that affect your traditional FX options. You will want to exercise the option at a profit if the market moves your way. Unlike a SPOT option, a traditional FX option does not pay off automatically. You have to instruct the forex broker to exercise the option.

  • Purchase a SPOT option by selecting any of the types offered by your forex broker. A glossary of "exotic" or SPOT options can be found at ForexDirectory.com (see Resources below). Enter the specifics of the currencies and rate scenario you propose and get a premium quote. If you accept the trade at the quoted premium, the rest is automatic. If you prove to be correct the profit will be deposited to your forex account.

Tips & Warnings

  • The bulk of forex trading volume is over-the-counter via the Internet. However, some FX options are traded on markets like the Chicago Mercantile Exchange. If you want to trade these exchange-listed options, you will need to open an options trading account with a conventional full service or discount brokerage firm that handles these securities

References

  • Photo Credit business charts with buy image by Andrew Brown from Fotolia.com
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