Currency Option Trading for Beginners
Trading currency options allows you to take advantage of fluctuations in currency exchange rates. Buying and selling currency options can increase your profits and losses because it allows you to deal with large amounts of currency by investing a small amount of money. As such, currency option trading carries great risk and is suitable only for sophisticated investors.
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Features
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Buying a currency option gives you the right, but not the obligation, to buy or sell a currency using another currency at a certain price known as the strike price. The difference between the strike price and the spot price, which is the prevailing price at the time of option purchase, affects the price at which you buy the currency option. The price of the option also depends on interest rates and price fluctuations of the two currencies.
Call Option
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Buying a call option gives you the right to buy a certain currency at a set strike price before or on the expiration date, which is a specified date in the future after which you forfeit your buying right. If you buy a call option, you make a profit if the price of the underlying currency goes up, because you would be able to buy it below market price. If the price goes down, you can choose not to exercise the option and let it expire.
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Put Option
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Buying a put option gives you the right to sell a certain currency at a set strike price before or on the expiration date. If you buy a put option, you make a profit if the price of the underlying currency goes down, because you would be able to sell it above its market value. If the price of the currency goes up, you can let the option expire and suffer a loss equal to the amount you paid at purchase.
Leverage
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With option trading, you can spend a relatively small amount of money to take advantage of price fluctuations on a larger amount of money. For example, assume you pay US$4,200 to buy a call option contract with a size of £62,500 (62,500 British pounds) at an exercise price of US$2.00/£. If the price of British pounds goes up to US$2.50/£, you can use your option contract to buy £62,500 at US$2.00/£ and immediately sell it for US$2.50/£, earning an investment payoff of US$31,250 (£62,500 multiplied by .50, the price increase). This would net you a profit of $27,050 (US$31,250 minus US$4,200), which is more than six times your initial investment of US$4,200.
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References
- Photo Credit international finance: currencies from around the image by Vladimir Melnik from Fotolia.com
