Summary of FOREX Option Trading
FOREX trades in currency pairs such as EUR/USD, the euro to dollar rate. The numerator is always equal to one, the denominator is how many units can be bought for one numerator unit. For example, a price of 1.2500 means that 1 euro will buy $1.25 of U.S currency. FOREX option contracts always pertain to a particular currency pair. There are several types of FOREX options, each with a specific risk/reward profile.
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Puts and Calls
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These FOREX options closely resemble stock options. Calls give the buyer the right, but not the obligation, to purchase the underlying asset (a currency pair) at an agreed price (the strike price) for a given cost (the premium) on or before an expiration date. Puts are similar, except they give the option buyer the right to sell a currency pair at the strike price. Exchanges such as the Chicago Mercantile Exchange (CME) list options for currency pairs with expiration periods ranging from a month to a year. Call buyers make money when prices increase; put buyers benefit from lower prices.
Single Payment Options Trading (SPOT) Options
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SPOT options are fairly simple: The trader buys or sells an option with a given strike price, called the barrier price, in the hope that the underlying currency pair will or won't hit the barrier before expiration. The trader decides the expiration date and barrier price, and the seller adjusts the premium and payout accordingly. SPOT options are over-the-counter products, i.e. they are not standard exchange-traded contracts. An example: A trader predicts that the EUR/USD pair will pierce the 1.3000 barrier within 9 days; if the trader is correct, he or she will receive a payout.
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Binary Options
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The North American Derivatives Exchange (NADEX) trades a standardized version of SPOT options called binary options. Contract size is $100. The payout is $1 per trading point (.0001 of a currency unit) per contract, and there are several expiration periods available ranging from a few hours through the end of the week. In this example, a trader purchases 7 EUR/USD contracts, which expire with a 14 point (0.0014) gain. Total profit is 7 multiplied by 14, or $98. The purchase price of a binary contract is the most a trader can lose. You can always trade away a binary option before expiration.
Exotic Options
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There are a number of over-the-counter FOREX options that are considered "exotic."
Knock Option -- a knock-in option is created if a currency pair reaches the barrier price. A knock-out option is terminated if a currency pair reaches the barrier price.
Lookback Option -- pays out relative to the highest price reached by a currency pair before expiration.
Double Lockout Option -- a bet that the underlying pair will remain within a given price range until expiration. Single-sided versions are bets on one end of a price range.
Range-Accrual Option -- similar to a double lockout, except the option accrues value depending on how long prices remain in or depart from a specified range.
Basket Option -- the buyer can receive multiple foreign currencies in exchange for a base currency at a designated strike price.
Options on Options -- these are compound options in which the underlying instrument is another option. There are calls on calls, puts on calls, puts on puts, and calls on puts.
Bermuda Option -- this is really just an option characteristic; it provides for option exercise only on or near the expiration date.
Asian Option -- the payout is based on the average price of the underlying currency pair during the contract period.
Ladder Option -- the owner can lock in gains throughout the contract period.
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References
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