Forex Options: What Are They and How to Trade Them?
If you are into trading and investments, you must have encountered the term Forex. Forex refers to the foreign exchange market where various currencies are exchanged worldwide.
Options are derivative contracts with which you, as the options holder, can get to buy and sell an asset at a fixed price on a given date in the future. If you are planning to trade in the forex exchange market, you need to have a clear idea of what forex options are and how you can use forex options trading.
Here is a detailed rundown on forex options, their types, advantages, and basic terminologies as well as a brief idea about how to start trading forex options. Let’s understand in more detail.
What Are Forex Options & How Do They Work?
A forex option gives a trader the right to either sell or buy currency at a particular date in the future and at a predetermined price. While a call option will provide you with the right to buy, the put option will give you the right to sell.
Forex options are basically derivative contracts that are based on currency pairs. These options are particularly influenced by factors affecting the underlying pair of currencies. These factors mostly include inflation, current geopolitical conditions, GDP, macroeconomic conditions, and other factors.
If you are looking forward to trading in forex options, you can either choose the American or European style. Depending on when the options are executed, forex options can be classified into American and European styles. In the case of the American style, you can exercise the option any time prior to the expiry date at a predetermined price. However, for the European style, you are allowed to exercise the option only on the set date of expiry.
As a trader, you can use the forex options trading strategy while trading in the foreign exchange currency market. But the strategy that you would use will mostly depend on the kind of option that you use and the expected market condition.
What Are the Types of Forex Options?
Now, let’s talk about the various types of forex options. Based on the underlying transactions, forex options are classified into two types:
- Call Option
A call option refers to any derivative contract that gives you the right to buy a particular currency before the expiration date at a particular price.
- Put Option
A put option, on the other hand, gives the holder the right to sell a particular currency at a pre-specified rate up to the specific expiration date.
Top Advantages of Forex Options Trading
Forex options trading can be quite beneficial if you are planning for foreign exchange trading. Some of the major benefits of forex options trading are as follows:
- You have the facility to take leverage on your position.
- You can be assured of a fixed pre-specified exchange rate.
- Another major advantage of choosing forex options is that there is a limited downside for the premium that you would pay.
- You can implement various bullish, bearish, or neutral strategies with the help of options contracts. You can use spread strategies, straddles, condors, vertical spreads, etc. using various options.
- One of the most notable advantages of using forex options is that it offers short-term hedges for positions in foreign currency as well as stock markets.
About Forex Options Trading in India
Are you interested in foreign currency trading in India? You can easily trade in forex options on any of the Indian exchanges, such as the Bombay Stock Exchange or the National Stock Exchange. However, you will need to opt for a broker or a trading platform.
Usually, European-styled put, and call options are prevalent in the Indian stock market. You can opt for cross-currency options as well as INR pairs. But please note that the trading hours on NSE are from 9 AM to 5 PM. The initial margin is charged according to the SPAN calculations. The premium amount will be in Indian currency and you have to pay the premium in cash. It has to be paid on a T+1 day basis.
While the daily settlement will take place on T+1 basis, the final settlements will take place on T+2 basis. The mode of the settlement will be in the form of cash.
There are different currency pairs that are available for forex options trading on Indian exchanges. Some of the most actively and popularly traded foreign currencies include Euro, Great Britain Pound, Japanese Yen, Chinese Renminbi, and others.
You can execute forex options on the day of the expiry only. But you can square off the positions prior to that by buying or selling the put or call options.
Some Common Terminologies Related to Forex
If you are planning to get into foreign exchange trading then you need to be aware of some of the basic terminologies. These are a few common terms that you need to know:
- Base Currency: It is the first currency that you would see in the forex quote.
- Quote Currency: It is the second currency that appears in the forex quote.
- Forex Quote: Forex quote refers to the base currency’s price with respect to another currency or the quote currency.
- Home Currency: This currency is the legal tender of the country that the trader is a citizen of. In other words, it is the currency of one’s own country. For example, in the case of the pair USD/INR, INR is the home currency of Indian nationals, and USD would be the home currency of the traders of the US.
- Direct quote: In the case of a direct quote, the base currency would be a foreign currency and the quote currency is the home currency. The direct quote for Indian traders would be USD/INR, where INR is the home currency which acts as the quote currency.
- Indirect quote: For the indirect quote, the foreign currency would be the quote currency while home currency will be the base currency. For example, INR/USD would be an indirect quote for Indian traders. Here, INR is the base currency being the home currency and USD will be the quote currency.
- Premium: It is the cost that you need to pay upfront for buying a foreign exchange option.
Before you go for forex options trading, you should know that it could be complex as it involves various types of risks. Some of these risks include market volatility, change in geopolitical situations and macroeconomic conditions, etc. Moreover, ensure the premium price isn’t too high for you. Forex options can give you an opportunity to make a profit on market predictions on the basis of news, global affairs, etc.
Frequently Asked Questions
Q1. What is a cross-currency swap?
Ans. In cross-currency swaps, two parties exchange interest payments and principal denominated in two different currencies. If you enter into this agreement, you need to exchange interest payments from time to time.
Q2. Is foreign exchange riskier than the stock market?
Ans. Yes, trading in foreign exchange can entail more risk than in the stock market. Also, it could be a bit difficult to predict or anticipate the challenges. Also, the leverage used in the forex market is high compared to the stock market. So, it can lead to higher losses.
Q3. What is meant by delivery date in forex options?
Ans. The delivery date is basically the date on which the currency exchange will happen in case the forex options are exercised.
Q4. What are vanilla options? Ans. Vanilla options contracts are the traditional agreements by which any trader gets the right but not the obligation to purchase or sell the underlying currency at a pre-specified price and date of execution. The traditional vanilla options either follow American or European expirations.