Now at this stage I will have to assume that you have a basic knowledge of options and the language of options – currency options trading is very similar, and if you are a little rusty, or simply new to options, then please visit my options site which I hope will make everything clear. You can find the link in the sidebar to the left. So, let’s start trading some vanilla currency options.

Now before we start, let me just clarify the terms long and short, as in the options world they mean slightly different things – when I say long I mean buying an option, and short is selling an option ( I hope that’s clear!) Remember also that calls go up in value as the underlying asset increases in value, and puts go up in value as the underlying asset decreases in value. So let’s start by comparing the spot fx market with a trade using a vanilla currency option.

  • Spot FX Market
  • Bullish On A Currency Pair
  • Buy in the spot market
  • Vanilla Currency Option
  • Bullish On A Currency Pair
  • Buy a call option

So, our first trade is very simple – we are bullish on the pair, and in the spot market we simply enter a buy order, and place a stop loss on the trade. The alternative in the options markets is to buy a call option with perhaps a one month expiry, and with a strike price in the area we feel is realistic for the period of the trade, perhaps 200 pips. Now as you may recall when you buy an options contract you have the right, but not the obligation, to exercise the contract – in other words your maximum risk is what you paid in premium for the option. Likewise in the spot market, your maximum risk is the stop loss. Now for arguments sake, let’s say the premium of the option and the stop loss had the same value – say $50.

The option is valid for a month and the market can whipsaw around with no effect on your position. In the spot market, your stop loss could be taken out in days, or even hours – do you repeat the trade and perhaps get stopped out a second, or even a third time, only to find in four weeks time that you were actually correct in your initial analysis of the direction.  So in buying the call, we have managed to avoid the problems of whipsaw in the market. Now clearly, it’s not as easy as that, as we have to worry about the time element of the option eroding more quickly as the option reaches expiry, along with various volatility issues, but the principle is very simple – using a currency call option, we have constructed a trade with a known risk, which requires no stop loss orders, and overcomes whipsaw. The same trade can be executed if we are bearish on the currency pair:

  • Spot FX Market
  • Bearish On A Currency Pair
  • Sell in the spot market
  • Vanilla Currency Option
  • Bearish On A Currency Pair
  • Buy a put option

In this case we simply replicate our spot fx trade by buying a put option. As the currency falls, the put option will increase in value as the agreed strike price is now above the underlying market price allowing us to exercise ( if we choose ) or sell the contract, which is now ‘in the money’ and therefore has intrinsic value.

OK – we’ve looked at a very simple strategy for using an option, instead of a spot market trade, when we are bullish or bearish in the market. Now what can we do if the market is neutral and simply moving sideways, but we think that the pair will take off soon, but we don’t know which way? – well, in the spot fx market the answer is very little, but in the options market we can construct a simple trade called a straddle. The strategy we are going to construct is the long straddle.

  • Spot FX Market
  • Currency pair neutral with likely volatility shortly
  • Wait and see which way the market moves
  • Vanilla Currency Option
  • Currency pair neutral with likely volatility shortly
  • Buy a put option and call option , at the money, and with same expiry and strike price.

Now here we have bought a long put and long call, so our maximum risk on the trade is the cost of the two premiums. For the strategy to be successful we need volatility in the market to move the pair significantly one way or the other with one of our options in profit, which then outweighs the cost of the options. Remember also that during the course of the trade, should the anticipated volatility not arrive, then we can always sell our options back to the market to reduce our loss on the trade. This is one of many strategies that we can use, all of which are based on those found in traditional options trading methods such as the strangle and the collar etc. I hope from the above, that you can start to get a feel for trading using currency options, but let me make the point now – I am not advocating that you should abandon the fx spot market and only trade options – far from it – they are an excellent instrument which should be used in conjunction with the spot market which is what we will look at next – hedging our positions using an option.