Forex option trading has emerged as an alternative investment vehicle for a lot of traders and investors. As an investment tool, forex option trading provides both large and small investors with greater flexibility when determining the right forex trading and hedging strategies to implement.
Most forex options trading is conducted via telephone as there are just a few forex brokers offering online forex option trading platforms.
Forex Option Defined - A forex option is really a financial currency contract giving the forex option buyer the right, but not really the obligation, to purchase or sell a specific forex spot contract (the underlying) in a specific price (the strike price) on or before a specific date (the termination date). The amount the forex option buyer pays to the forex option seller for that forex option contract rights is called the forex option "premium. "
The Forex Option Buyer - The customer, or holder, of a foreign currency option has the choice to either sell the foreign exchange option contract prior to expiration, or he or she can choose to hold the foreign currency options contract until expiration and exercise his / her right to take a position in the underlying spot foreign currency. The act of exercising the foreign currency option and taking the subsequent underlying position in the foreign currency spot market is called "assignment" or being "assigned" a spot position.
The only initial financial obligation from the foreign currency option buyer is to pay the premium to the seller in advance when the foreign currency option is initially purchased. Once the premium is actually paid, the foreign currency option holder has no other financial obligation (no margin is required) before foreign currency option is either offset or expires.
On the expiration day, the call buyer can exercise his or her right to buy the underlying foreign exchange spot position at the foreign currency option's strike price, and a put holder can exercise his / her right to sell the underlying foreign currency spot position at the foreign exchange option's strike price. Most foreign currency options are not exercised by the customer, but instead are offset in the market before expiration.
Foreign currency choices expires worthless if, at the time the foreign currency option expires, the actual strike price is "out-of-the-money. " In simplest terms, a foreign currency option is "out-of-the-money" when the underlying foreign currency spot price is lower than a foreign currency phone option's strike price, or the underlying foreign currency spot price is greater than a put option's strike price. Once a foreign currency option has run out worthless, the foreign currency option contract itself expires and neither the buyer nor the vendor have any further obligation to the other party.
The Forex Option Seller - The foreign currency option seller can also be called the "writer" or "grantor" of a foreign currency option contract. The vendor of a foreign currency option is contractually obligated to take the opposite underlying foreign exchange spot position if the buyer exercises his right. In return for the premium paid through the buyer, the seller assumes the risk of taking a possible adverse position at a later time in the foreign currency spot market.
Initially, the foreign currency option seller collects the premium paid through the foreign currency option buyer (the buyer's funds will immediately be transferred to the seller's foreign currency trading account). The foreign currency option seller must have the money in his or her account to cover the initial margin requirement. When the markets move in a favorable direction for the seller, the seller won't have to post any more funds for his foreign currency options other compared to initial margin requirement. However, if the markets move in an unfavorable direction for that foreign currency options seller, the seller may have to post additional funds to his / her foreign currency trading account to keep the balance in the foreign forex trading account above the maintenance margin requirement.
Just like the buyer, the foreign exchange option seller has the choice to either offset (buy back) the foreign exchange option contract in the options market prior to expiration, or the seller can decide to hold the foreign currency option contract until expiration. If the foreign foreign currency options seller holds the contract until expiration, one of two scenarios may occur: (1) the seller will take the opposite underlying foreign currency spot position when the buyer exercises the option or (2) the seller will simply let the foreign exchange option expire worthless (keeping the entire premium) if the strike price is actually out-of-the-money.
Please note that "puts" and "calls" are separate foreign currency options contracts and therefore are NOT the opposite side of the same transaction. For every put buyer there's a put seller, and for every call buyer there is a call vendor. The foreign currency options buyer pays a premium to the foreign currency options seller in most option transaction.
Forex Call Option - A foreign exchange call option provides the foreign exchange options buyer the right, but not the obligation, to buy a specific foreign exchange spot contract (the underlying) at a specific price (the strike price) on or before a particular date (the expiration date). The amount the foreign exchange option buyer pays towards the foreign exchange option seller for the foreign exchange option contract rights is known as the option "premium. "
Please note that "puts" and "calls" are separate foreign currency options contracts and are NOT the opposite side of the same deal. For every foreign exchange put buyer there is a foreign exchange place seller, and for every foreign exchange call buyer there is a foreign currency call seller. The foreign exchange options buyer pays a premium to the foreign currency options seller in every option transaction.
The Forex Put Option - A foreign currency put option gives the foreign exchange options buyer the right, but not really the obligation, to sell a specific foreign exchange spot contract (the underlying) in a specific price (the strike price) on or before a specific date (the termination date). The amount the foreign exchange option buyer pays to the foreign currency option seller for the foreign exchange option contract rights is called the possibility "premium. "
Please note that "puts" and "calls" are separate foreign exchange options contracts and therefore are NOT the opposite side of the same transaction. For every foreign exchange put buyer there's a foreign exchange put seller, and for every foreign exchange call buyer there's a foreign exchange call seller. The foreign exchange options buyer pays a premium towards the foreign exchange options seller in every option transaction.
Plain Vanilla Forex Options - Plain vanilla options generally make reference to standard put and call option contracts traded through an exchange (however, regarding forex option trading, plain vanilla options would refer to the standard, generic forex option contracts which are traded through an over-the-counter (OTC) forex options dealer or clearinghouse). In easiest terms, vanilla forex options would be defined as the buying or selling of the standard forex call option contract or a forex put option contract.
Exotic Forex Options - To comprehend what makes an exotic forex option "exotic, " you must first know very well what makes a forex option "non-vanilla. " Plain vanilla forex options have the definitive expiration structure, payout structure and payout amount. Exotic forex option contracts may have a change in one or all the above features of a vanilla forex option. It is important to observe that exotic options, since they are often tailored to a specific's investor's requirements by an exotic forex options broker, are generally not very liquid, if.
Intrinsic & Extrinsic Value - The price of an FX option is actually calculated into two separate parts, the intrinsic value and the extrinsic (time) worth.
The intrinsic value of an FX option is defined as the difference between your strike price and the underlying FX spot contract rate (American Style Options) or even the FX forward rate (European Style Options). The intrinsic value represents the particular value of the FX option if exercised. Please note that the intrinsic value should be zero (0) or above - if an FX option has no innate value, then the FX option is simply referred to as having no (or zero) intrinsic value (the intrinsic value is never represented like a negative number). An FX option with no intrinsic value is considered "out-of-the-money, " an FX option having intrinsic value is recognized as "in-the-money, " and an FX option with a strike price at, or very near to, the underlying FX spot rate is considered "at-the-money. "
The extrinsic value of an FX option is commonly known as the "time" value and is defined as the value of an FOREX option beyond the intrinsic value. A number of factors contribute to the calculation from the extrinsic value including, but not limited to, the volatility of the 2 spot currencies involved, the time left until expiration, the riskless interest price of both currencies, the spot price of both currencies and the strike price from the FX option. It is important to note that the extrinsic value associated with FX options erodes as its expiration nears. An FX option with 60 days left to expiration is going to be worth more than the same FX option that has only 30 times left to expiration. Because there is more time for the underlying FX spot price to possibly relocate a favorable direction, FX options sellers demand (and FX options buyers are prepared to pay) a larger premium for the extra amount of time.
Volatility - Volatility is the most important factor when pricing forex options and it measures movements in the buying price of the underlying. High volatility increases the probability that the forex option could expire in-the-money and boosts the risk to the forex option seller who, in turn, can demand a bigger premium. An increase in volatility causes an increase in the price associated with both call and put options.
Delta - The delta of a forex option is understood to be the change in price of a forex option relative to a change within the underlying forex spot rate. A change in a forex option's delta could be influenced by a change in the underlying forex spot rate, a alter in volatility, a change in the riskless interest rate of the underlying spot currencies or just by the passage of time (nearing of the expiration date).
The delta must always be calculated in a variety of zero to one (0-1. 0). Generally, the delta of a deep out-of-the-money forex option is going to be closer to zero, the delta of an at-the-money forex option will end up being near. 5 (the probability of exercise is near 50%) and the delta of deep in-the-money forex options is going to be closer to 1. 0. In simplest terms, the closer a forex option's strike price is in accordance with the underlying spot forex rate, the higher the delta because it is more sensitive to some change in the underlying rate.