Understanding Forex options: A guide for UK traders

Forex (FX) options are akin to equity options, providing the right, but not obligation, to buy or sell a currency pair at a specific price (strike price) on a specific date (expiry). The option buyer typically compensates the option seller with a premium. Importantly, in FX options, purchasing a call option on one currency implies a put option on the other currency.

Types of FX options

FX options come in two forms: calls and puts. Buying a call option gives the right to buy a currency pair, while buying a put option provides the right to sell. Selling options involves the obligation to sell (call) or buy (put) at a pre-determined price on the expiry date, for which a premium is received.

Let's illustrate this with a EURUSD call and put options example:

Assumption: Buy/Sell 100,000 EURUSD Call/Put option at strike 1.07 with 2-month tenor for 0.0150 (150 pips), P&L in USD.

Buying FX options

Traders often buy Out-of-The-Money (OTM) calls or puts to make directional bets on a currency pair. OTM options are cheap, providing high leverage but are most susceptible to time decay. At-The-Money (ATM) options, sensitive to volatility and underlying price changes, are pricier but more likely to expire in the money. In-The-Money (ITM) options have high intrinsic value and function much like spot positions but offer little leverage.

To reduce the premium paid, traders often use option strategies such as call spreads, put spreads, collar strategies and risk reversals.

Selling FX options

Selling FX options can generate income by receiving a premium. The option seller is paid to protect the buyer from market fluctuations. The maximum gain is the premium received, but the losses can be unlimited.

Selling put options can be a strategy for bullish traders, while selling call options might appeal to bearish traders.

Key differences between FX and equity options

1. FX options are traded over-the-counter (OTC), allowing for customisable size, strike price and tenor.
2. They are European-style options, meaning they can only be exercised on the expiry date.
3. Exercising an FX option results in an FX margin position, requiring less capital than a fully funded cash position.

Benefits of trading FX options

1. Buying FX options caps the maximum loss to the premium paid, avoiding margin calls due to mark-to-market losses.
2. Selling FX options can supplement portfolio returns through a steady premium income.
3. FX traders often use options as proxy take profit or stop loss orders for their spot trading.

Risks of trading FX options

1. Selling FX options could result in unlimited loss due to high leverage.
2. Using FX options as a proxy for taking profit or entering a position can be risky as the option might move in favour before expiry but be out-of-money at expiry.