If you have heard the term forex market, you would also want to know the strategies and functions of trading. Forex options trading helps you to understand the basics of trading in the forex market.
Let’s dive deep into the process and functions and understand how you can profit using forex options trading.
What is the forex or currency option?
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A forex option (also referred to as a currency option) is an agreement that gives you the right but no obligation to buy or sell a particular currency on a pre-agreed exchange rate, on or before a specified time.
In other words, the forex option is a financial instrument where different strategies are put through like, selecting a choice and choosing a broker or a platform through which the option is offered.
You can also sell an option contract and collect a premium in exchange for it. Most corporations, individuals, and financial institutions prefer the forex option to hedge against unpropitious movements in exchange rates.
Essential keys to understanding forex options trading
- The attributes of the forex option in decentralized forex markets vary much more widely than the options in more centralized exchange markets.
- Options traded in the forex markets differ from the other exchange markets as the traders are allowed to trade without taking actual delivery of assets.
- Traders can choose the exchange rates and expiration dates according to their hedging or profit strategies.
- The forex options vary from one product to another, depending upon which entity is offering the option.
Basic terminology for forex option trading
If you want to trade options in the forex market, you need to understand its complexity that adjoints various types of terminologies, acronyms, and words.
The conjunction of different functions and processes can overwhelm a trader. Read on to know basic terminology for forex options trading.
180 recognized currencies are circulating in the forex exchange market used by 195 countries. It can help a trader to determine the relative value of one currency to another in the marketplace.
When you select a currency to trade, you will notice that it appear in pairs. Let me explain to you EUR/USD currency pair.
If 1 EUR= 1.24 USD
You would be betting on Euro as it has a high value compared to US dollars.
Now, if the value increases by 1.30 USD
You gain a 0.6 profit on 1 EUR.
Leverage makes forex options trading more accessible as it allows you to open a position of large contract size without investing a large amount of capital.
Suppose you were to invest $100,000 in the forex market.
You buy 100 xyz currency for $ 1000 each.
Let’s say 1000 units went up by 1005
Your profit for the day is $5 currency *100 = $500
But the broker lends you money and increases your capital to $1000,000.
Now your profit is $5 currency *1000 = $5000
Therefore, leverage multiplies your trade size, although no money changes hands.
It is the market price for the sale of a currency pair. The trader bids the price on which he/she is willing to sell a currency pair.
This is the market price for buying a currency pair. The trader asks for the price at which he/she is prepared to purchase a currency pair.
Long position (buy)
A long position refers to purchasing a currency, expecting its market price to rise.
For instance, AUD/USD.
In this case, the trader buys the first currency in a pair and sells the second one.
Short position (sell)
A short position refers to selling a currency, expecting its market value to fall. The trader sells the first currency and buys the second one.
The abbreviation PIP stands for Percentage In Point.
It is the minor prize rate that a given exchange rate can make. An increase or decrease in pips denotes profit or loss in your forex trade.
When the currencies are quoted, it is quoted till 4th decimal place, except Yen (Japanese) which mentioned till 2nd decimal place.
Let’s take the EUR/USD pair as a case.
If 1 EUR= 1.3130 USD
And if the value moves to 1.3131 USD
It means that the value has moved by 1 pip because the 4th decimal point increased by 1.
When you trade in a forex market, you trade in blocks or ‘units.’ These units are called lots.
There are 3 basics lot sizes.
Micro lot- $1000 worth of currency control
Macro lot- $ 10,000 worth of currency control
Standard lot- $ 100,000 worth of currency control.
Margin is the commencing capital required to open and maintain the opening position.
Margin should not be confused as a transaction charge or fee for trading. It is simply a down payment to open a position in the forex market.
Types of forex options
There are primarily two types of forex options.
Call option: It gives an option holder the right(but not an obligation) to buy units of a currency pair at an agreed-upon value on or before a particular date.
Put option: It gives an option holder the right (but not an obligation) to sell units of a currency pair at an agreed-upon value on or before a particular date.
In layman’s terms, let’s assume you bought a call option holder.
The pre-agreed prize (also called strike price) is $120
A particular date (also called expiration date) is 30 days.
Holding the call option will allow you to purchase a currency pair at $120 per unit anytime during the next 30 days, regardless of the high currency value.
In the case of the put option, you can sell the currency pair at $ 120 per unit anytime during the next 30 days, no matter how low the value drops.
Benefits of forex option
Every trader has different aspects and thought for trading in the forex market. It is vital to understand your preferable space at times of trading.
5 significant benefits of forex options trading.
- It has a global market– The forex options trading is the largest globally, worth $5 Trillion. The market is open 24 hrs a day, making it a global platform to trade in.
- Benefit from leverage– As mentioned earlier, leverage helps a trader to open a position in a large size with a relatively small amount of initial capital.
Leverage helps a small trader accelerate the accessibility of getting more profit by taking more risk.
- No loss more than initial capital– You can only lose your down payment or the premium you paid while purchasing the forex option.
- High liquidity market– A nature of a highly liquid market allows the ease of exchange of currency pair with limited effect on its value.
- Advance technology for trading– There are several platforms from which a trader can trade in the forex market. Its decentralized nature allows the software developers to improve the platforms available consistently.
Forex trading option is the growing global market. Though this is the biggest market, it is still not widespread in developing countries like India.
Forex options trading should not be mistaken for the get-quick-rich scheme. It takes a long-term strategy that requires knowledge and patience in the marketplace.