Here are discussed forex options, the way they are used, and strategies you are to use to gain and increase profit. Many people suppose the stock market when they think of options; nevertheless, the foreign exchange (FOREX) market also offers the occasion to trade these distinctive derivatives. These options give retail traders a chance to limit their risk and enlarge their profit.

Types of FOREX Options
There are two key types of options that are available to retail FOREX traders. The most familiar is the traditional call/put option, that is similar to the respective stock option. The other option is single payment option trading--or SPOT--which gives traders more elasticity.

Traditional Options
Fixed options allow the buyer not the obligation but the right to purchase something from the option seller at a set price and time. For instance, a trader might purchase an option to buy two lots of EUR/USD at 1.3000 in one month; such a contract is identified as a "EUR call/USD put." (Take into account that, in the options market, when you buy a call, you buy a put simultaneously – just as in the cash market you buy one currency and simultaneously sell another.) If the price of EUR/USD is lower than 1.3000, the option expires worthless, and the buyer loses only the premium. Conversely, if EUR/USD skyrockets to 1.4000, then the buyer can work out the option and gain two lots for only 1.3000, which can then be sold for profit.

Since FOREX options are traded over-the-counter (OTC), traders can select the price and date on which the option is to be valid and then accept a quote stating the premium they must pay in order to gain the option.

There are two types of traditional options offered by brokers:

European-style – This option can be exercised only at the point of expiration.
American-style – This option can be exercised at any time up until expiration.

One merit of traditional options consists in their lower premiums than that of SPOT options. Also, for the reason that (American) traditional options can be bought and sold before expiration, they allow for more flexibility. On the other hand, traditional options are more problematical to set and execute than SPOT options. (For more detailed information about options, see "Options Basics.")

Single Payment Options Trading (SPOT)
SPOT options work in that a way: the trader inputs a scenario (for instance, "EUR/USD will break 1.3000 in 12 days"), obtains a premium (option cost) quote, and then receives a payout if the scenario is executed. In essence, SPOT automatically converts your option into cash when your option trade is successful, and it gives you a payout.

Many traders benefit from the additional choices (listed below) that SPOT options give traders. Moreover, SPOT options are simple to trade: it's a matter of entering the scenario and letting it play out. You receive cash into your account if you are accurate. But if you are incorrect, your loss is your premium. An additional advantage is that SPOT options offer a choice of many diverse scenarios, allowing the trader to choose precisely what he thinks is going to happen.

A demerit of SPOT options, however, is their higher premiums. Generally, SPOT option premiums cost much more than standard options.

Why Trade Options?
Here is given a number of reasons why options normally appeal to the traders:
• Your drawback risk is limited to the option premium (the amount you paid to purchase the option).
• You pay less money up front than for a spot (cash) FOREX position.
• You have unrestrained profit prospectives.
• You can set the price and expiration date. (Unlike those of options on futures these are not predefined.)
• Options can be used to hedge against open spot (cash) positions with the purpose of limiting risk.
• Without risking a lot of capital, you can use options to trade on predictions of market movements before essential events happen (for example, economic reports or meetings).
o SPOT options give you many opportunities:
o Standard options.
o One-touch SPOT – You receive a payout if the price touches a definite level.
o No-touch SPOT – You receive a payout if the price doesn't touch a definite level.
o Digital SPOT – You receive a payout if the price is above or below a definite level.
o Double one-touch SPOT – You receive a payout if the price touches one of two set levels.
o Double no-touch SPOT – You receive a payout if the price does not touch any of the two set levels.

Evidently, there are some downsides to using options as well:
• The premium fluctuates according to the strike price and date of the option, so the risk/reward ratio fluctuates.
• SPOT options can’t be traded: once you buy one, you cannot come round and then put it up for sale.
• It can be hard to forecast the exact time period and price at which movements in the market may take place.
• You can be going against the odds.

Options Prices
Options are determined by some factors that as a group establish their value:
• Intrinsic value – It shows how much the option would be worth if it were to be exercised right away. The position of the current market price relative to the strike price may be described in one of three ways:
o "In the money" - That means the strike price is higher than the current price.
o " Out of the money" – That means the strike price is lower than the current price.
o " At the money" – That means the strike price is at the current price.
• The time value - That represents the uncertainty of the price in due course. Commonly, the longer the time is, the higher premium you pay because the time value is larger.
• Interest rate differential - A change in interest rates affects the bond between the strike of the option and the current market rate. This effect is often factored into the premium as a function of the time value.
• Volatility - Higher volatility raises the probability of the market price hitting the strike price in a limited time period. Volatility is featured into the time value. On average, more volatile currencies have higher options premiums.

How It Works – A Scenario
Let it be January 2, 2004, and you believe that the EUR/USD (euro vs. dollar) pair, which is presently at 1.3000, is headed downward due to positive U.S. numbers; in the same way, there are a number of major reports coming out soon that could cause significant volatility. You suspect this volatility will take place within the next two months, however, you don't want to risk a cash position, and thus, you come to a decision to use options.

You then go to your broker and apply for buying a EUR put/USD call, generally referred to as a "EUR put option," set at a strike price of 1.2900 and an expiry of March 2, 2004. The broker tells you that this option will cost 10 pips, so you willingly decide to buy it.
Your order would be somewhat like that:
Buy: EUR put/USD call
Strike price: 1.2900
Expiration: 2 March 2004
Premium: 10 USD pips
Cash (spot) reference: 1.3000
Say the new reports appear and the EUR/USD pair falls to 1.2850 – you decide to exercise your option, and the result brings you 40 USD pips profit (1.2900 – 1.2850 – 0.0010).

Option Strategies
Options may be used in various ways, although they are generally used for one of two purposes: they are (1) capturing profit or (2) hedging against existing positions.

Profit Motivated Strategies
Options are a good method to profit as keeping the risk down – in any case, you lose no more than the premium! Most of FOREX traders prefer using options about the time of important reports or events, when the spreads and risk rises in the cash FOREX markets. Some other profit-driven FOREX traders merely use options in preference to cash because options are cheaper. An options position can make a great deal more money than a cash position in the equivalent amount.

Hedging Strategies
Options are a great technique to hedge against your existing positions to reduce risk. Some traders still use options in place of or in concert with stop-loss points. The main advantage of using options in concert with stops consists in the following: you have an unlimited profit potential in the event that the price continues to move against your position.

Hedge ratio
An option price does not alter in a one-to-one association with the fluctuations in the price of the basic asset. This is for the reason that as the option strike price becomes closer to or further away from the current asset price, the likelihood of the strike price being in the money changes. Above, you can see the relation of the option price to the underlying asset price. The word used to explain the relationship of the option’s price change to the underlying asset’s price change is the hedge ratio or delta. As you see, when the option becomes more and more heavily in the money, the option value’s price will vary very much with the underlying asset price, meaning that the delta is approaching 1. However, when the strike price becomes further and further out of the money, the delta approaches zero, as the likelihood that the option will have any intrinsic value on expiration also approaches zero.

Hedging with options
Options are frequently used in combinational strategies with other options, or like a hedging tool for a spot position. A hedging strategy can be initiated to decrease a potential loss on the investment. In the event that the investor buys a spot position at a price of 100, he has a profit/loss scenario as shown below. The investor can change the profit/loss scenario and reduce a potential loss if he buys a put option. This is illustrated in the graph below, too. The advantage of hedging with options as opposed to using a ”stop” is that you can stay in the market despite movements against your underlying position and still have an unlimited profit scenario. The disadvantage is having a larger gain in the spot before the position makes a profit since you must pay for the option.

Hedging example
You hypothesize that the exchange rate of EURJPY will turn down suddenly next week and have the capital to sell 1,000,000 EURJPY on margin at the spot price of 105.00. At this time you feel like protecting your position in case of a rise in the EURJPY rate.

Protection is possible in two ways:
1) you can place a stop order, or
2) buy an option.

1) Placing a stop
Let’s say that you speculate placing a stop, based on your study, at 106.00. By means of placing a stop order, you will, obviously, limit the potential for loss to JPY 1,000,000 (around 9,434 EUR) if the stop (106) is traded, in that way closing your position.

2) Buy an option
The other method of protecting yourself from limitless downside in this scenario is purchasing a call option. Given that you purchase a one-week call option with the same strike price as the stop-loss order (106.00) at a price of JPY 300,000 (EUR 2,857). As the holder of this option, you will uphold the potential for unlimited profit for the reason that your spot position can stay open in anticipation of the exercise date without having to be concerned about losing more than the option premium (JPY 300,000) and the (JPY 1,000,000) loss when the price is at 106.00. The option will keep any final price above that level. That’s because the call option gains value at the same time as the spot loses value. In other terms, this option scenario can give you a staying influence that is not possible with the use of stops. Entering the market several times and hitting multiple stop losses is much more costly than establishing a more strategic options position. That is particularly exact in cases with high volatility.

In the graphic below, the two strategies are shown. The thick blue line shows the loss/profit scenario for the hedged position. Remember that in sideways markets, an option buying strategy can become costly for the reason that you are paying for time value that quickly erodes when the expiration date approaches.

Profit and Loss – Hedge
Another possible benefit of a hedging strategy is the following: in the course of the option’s life, you may reconsider your view of the market and wish to close in fact the short spot position (even at a loss) in the anticipation that the market is going the other way. In this scenario, you close the short position but continue keeping the option, hoping that it will come in the money before expiration.

For instance, let’s suppose that after a few days, the spot price for EURJPY increases to 105.50 from the entry level of 105.00, furthermore, you have changed your mind about the trend of the market. In view of the fact that you believe the rate will continue to rise, you close your spot position for a loss, but hold on to your option until the expiration. At every level above the break-even point of 106.3 you are making a profit. All over again, the option itself might be resold before expiration.