Investor Jim,
What is forex option trading and how does it work?
Gregory

Gregory,
First of all, forex trading is the buying and selling of different currencies in the foreign exchange market. Since prices of currencies change constantly due to a lot of different factors, taking into account that a down swing of a price will most likely be followed by an upswing in price in a more stable currency, a profit can be made by buying currency when the price is low and selling it when it is high.

A foreign exchange option or forex option is a financial instrument or financial contract where an owner or buyer is given the right but not the obligation to exchange one form of currency to another in a pre agreed price or exchange rate (strike price) and set within a pre agreed time (expiration date). This allows the trader who holds the forex option to buy a currency at a fixed exchange rate and when the time comes that the exchange rate in the forex market is favourable to the owner, the owner can opt to buy the currency and sell it in the market for a good amount of profit.

Here is how it works: say a trader offers to buy a certain volume of currency A from another trader in exchange for a certain volume of currency B for a fixed exchange rate or strike price of say one B is to two A (1B=2A) on or before a set date. Then, sometime before the expiration date a favourable spot price or exchange rate in the current market comes along, say one B is to 1.9 A (1B=1.9A), where currency A is stronger than currency B, the buyer can opt to buy the option and trade what the buyer got in the market making a nice profit. (2A * (1B / 1.9A) = 1.0526B, 0.0526 greater than the price sold through the option)

When a buyer and seller get into an options contract, the buyer will have to pay a premium up-front to the seller to give some security to the seller. The seller will keep the premium whether the buyer exercises the right to sell the options contract or not. When the contract expires and the exchange rate in the current market is lower than the strike price, the options contract is deemed worthless or out-of-of-the-money.

Forex option trading is widely popular because of the high rewards it can give as compared to waiting and predicting fluctuations and trends in currency prices. Forex options allow traders some room to think of strategies that one will implement. Most of the transactions involving foreign exchange option trading are over-the-counter transactions. That is why it is easy to implement, because no third parties may be involved therefore no commissions need be given out. It is also lightly regulated and large volumes of forex options are traded everyday. Forex option trading though doesn’t need to be taken lightly. The complexity of the details of the trade alone needs a certain amount of comprehension and education in order to be clearly understood.

Investor Jim