Currency Options Trading - Why Trade Options?
A good question, and one I am often asked particularly as currency options trading is often seen as difficult and complex, when compared to the very straightforward spot currency trades now offered by an increasing number of online brokers. I hope that this page will give you an answer to the question, but also to highlight some of the issues that you need to be aware of in using currency options as part of your trading strategy.
Currency Options Trading - Advantages
Let's talk about the vanilla options first and then the exotic options :
Vanilla Options :
- Reduced need for stop loss
- If you have ever been stopped out repeatedly, only to be proved right in the longer term, then you will understand this one! Options reduce the need for a stop loss when used as a hedge, and can smooth out the whipsaw effect which takes trades out of the market. Excellent for hedging risk in the spot market.
- Fixed loss
- If you trade long puts and calls, your downside risk is always defined. Your exposure to the market is the premium and no more. In addition, with a long call or put you have unlimited profit potential.
- Easy to trade
- In the last 12 months the market for currency options has grown dramatically, with most of the major exchanges offering them. Liquidity is excellent.
- Market prices and transparency
- Prices on the exchanges are driven by market forces, providing fair pricing, narrower spreads and an array of exchanges for best execution.
- Variety of trading strategies
- Options can be combined to provide traders with the flexibility to make money, even in neutral markets.
- Cost of the position is less
- An option position is more cost effective that a spot currency position which will require considerably more upfront cost in margin etc
Exotic Options :
- Simple to understand
- Unlike vanilla options, the strategy is very simple to understand and execute.
- Defined risk/reward
- Downside risk is limited and reward is defined and known before entering the trade
Currency Options Trading - Disadvantages
Vanilla Options :
- Time
- As an option holder time works against you and the closer to expiry the faster time melts away reducing any value left in the option
- Limited pairs
- Options are only available on the majors at the moment, and not on the crosses
- Trading hours
- Options used to only be traded in normal exchange hours - for the ISE this was 9.30 am to 4.15 pm EST - many exchanges are now starting to move towards 24 hour trading on electronic platforms - ( CME is one )
Exotic Options :
- No flexibility
- A SPOT contract cannot be traded. Once you have bought the option you cannot then sell it back to the broker.
- Against the odds
- According to CBOE data, option sellers are considerably more profitable in the long term than option holders.
- Higher costs
- As these are OTC trades the premiums will be higher then vanilla options as there is no open market trading. Pricing will vary from broker to broker and may not be fair or reflect true market conditions.
OK, now that we've looked at some of the pro's and con's of currency trading options, I would just like to spend a few moments looking at how vanilla options are priced on the exchanges, and then we can consider some of the strategies available, and how we would implement these to improve our trading returns.
Currency options trading - next page
