Knowing the Key Differences Between Forex and Stock Options
Many investors will automatically think of stocks when options are mentioned in a conversation. Options are contracts that grant the owner the right but not the obligation to buy or sell 100 shares of an underlying stock for a set price by an expiration date - for a premium that must be paid regardless of whether the option is ever actually exercised or not. There are many strategies for investing with options and many involve hedging against a loss on other investments.
There are two basic options, the call (where the price of the security is expected to rise prior to expiration date) and the put (prices are expected to drop before the expiration date). When an investor purchases a call option, he/she makes a profit when the market price exceeds the exercise price before the expiration date - the opposite is true for puts. Forex options involve calls and puts but come in two basic varieties: Traditional and Single Payment Options Trading (SPOT).
Traditional options are very similar to stock options and they are defined as contracts that grant the owner the right but not the obligation to purchase a given amount of currency from the seller at a given price by a certain date. However, there are some differences between traditional Forex options and their stock counterparts. For instance, when a buyer purchases a lot of 1.2500 US/CAN, the transaction is recorded as a US call / CAN put.
Forex options operate under the same principle as the currency market itself (i.e. an investor buys one currency by simultaneously selling another). When an investor buys a call for one currency, he/she buys a put at the same time for the other currency in the pair. So if an investor were to buy a Forex option for two lots of US/CAN at 1.2500 that expired in one month, he would be buying a US call/CAN put option. If the currency exchange rate does not rise above 1.2500 by the time the option expires, the investor will lose the premium.
Another key difference between stock and Forex options is that the FX market is not regulated in the same way that the stock market and many other investment avenues are. Forex options are not traded via any formal exchange. Instead, transactions are all arranged via a network of traders. Therefore, all Forex options are simply created by traders where they determine the price and date at which the option becomes profitable. The writer of the option will obtain a premium while the buyer will wait to see if the investment pays off by the time of expiration. However, there are two types of traditional Forex options available: American and European style. If an investor has an American style Forex option, it can be exercised at any time prior to expiration. However, if the investor has a European Forex option, then they must wait right up until it is about to expire before being able to exercise it. The only real drawback to Traditional Forex options is that it can be difficult to arrange and execute trades. However, SPOT options solve this problem while still providing investors with a good investment tool to use in the currency exchange market.
SPOT options are far easier to trade and convert into cash when investors are successful. Basically, an investor merely imagines a future movement in an exchange rate between a currency pair within a given time frame. The price of the option (premium quote) will depend upon the likelihood of the occurring scenario. Generally speaking, a higher degree of fluctuation in the exchange rate in a short period of time will command a lower premium as large fluctuations are an unlikely scenario given the long-term stability of rates.
The real beauty of SPOT options is their simplicity. An investor merely imagines (foresees) a possible scenario for a currency pair and if the pair acts as predicted, there is a payout. Investors set up SPOT accounts with traders and companies specializing in these Forex options. The investor simply picks a currency pair, predicts what the future exchange rate will be by a certain date (this is also up to the investor), and the trader will be given a premium quote. If the investor accepts the premium, this amount will be deducted from the trading account. Should the option not play out the way it was expected, the investor simply loses the premium amount. However, if the investor predicts the exchange rate fluctuation correctly, then the payout is deposited into the trader's account.
For investors new to SPOT options and who are unsure of just what kind of scenarios to predict, there are a number of choices available that help newcomers. There is a One-Touch Spot option that will payout if the exchange rate simply reaches a certain level before the expiration date. These will have a limited payout that is determined both by the duration of the option and the difference between the One-Touch amount and current exchange rate at the time investor purchases the option.
There is also a No-Touch Spot option where the investor receives a payout if the exchange rate on a currency pair does not reach a certain level before expiration (this can apply to call or put options). An investor may choose this Forex Spot option if he/she thinks that the market is incorrect in its future predictions for the exchange rate on a certain currency pair (say the EUR/USD). The market may think that the EUR will continue to gain ground against the dollar in the coming month. However, an investor may think that the dollar will indeed lose ground but not as much as anticipated. If so, the investor may choose a No-Touch Spot option with a lower level than the market predicts. If that level is not reached, the investor receives a payout. Again, maximum profit is limited to total payout and maximum losses are limited to premium price paid for option.
There are other preset SPOT options which are just variations of the One Touch and No Touch options. The fact remains that SPOT options are very simple and many investors love writing them and seeing if their predictions come true and receiving the payout. While many investors new to Forex Spot options will begin with the standard One Touch and No Touch options, they usually end up writing their own options with different scenarios.
When creating a SPOT option, investors benefit because they are setting their own price and expiration date - there is complete control over the transaction. The premium quote is the only variable that the Forex trader has no control over and this price is determined by the strike price, expiration date, and risk/reward ratio - all of which are in the investor's control when writing the option. If an investor writes an option and does not like the premium quote, there is no obligation to buy the option. However, once a SPOT option has been purchased, the investor is stuck with it. Unlike stock options which can be sold back to the market prior to the expiration date, Forex SPOT options cannot be traded.
SPOT options allow investors to establish a position for less initial capital than would be necessary to create a typical cash position on the Forex market. SPOT options can also be used to speculate on future market movements before major fundamentals are released so that it may be possible to make bigger profits from the resulting market adjustments.