Differences between Currency Options Trading and Forex Trading

Differences between Currency Options Trading and Forex Trading

Posted on 02. Sep, 2010 by in Forex

Many of us who are unfamiliar with the different types of currency investing and trading hear the term Forex and think that it is a catch all term for any sort of investment involving more than one currency.  While the Forex market has gained the lion’s share of attention, currency options trading is in many instances the more practical and less volatile side of currency exchange.  It allows stability in a very unpredictable market and greatly lowers the uncertainty involved in exchanging large amounts of money.

How Does Currency Options Trading Work

Unlike Forex trading, which takes place in real time and requires rapid decisions, currency options trading is all about hedging your bets for the future.  In simple English, to buy a currency option is to buy the right or option to exchange a specified amount of Currency A at a certain exchange rate (usually the current one) into Currency B at a specified date in the future.  It in effect fixes the exchange rate so that that money has a known pre-determined value on both sides of the trade.

For example, let’s say that an American wants to buy a house in Europe.  They have agreed on a price of 150,000 Euros with the money to be paid a month from today.  The American may have the equivalent of 150,000 Euros today in his bank account, but he also knows that if the exchange rate moves even by a penny the cost to him will change by over $2,000.  Therefore, he will buy a currency option letting him trade the dollar amount his house would cost him today for the 150,000 Euros.

The American can now be confident that no matter what happens to the exchange rate in the next month, he will have sufficient funds to buy his European home.  If by chance the exchange rate moves in his favor so that on the day he must pay for the house, it actually costs him thousands less than he expected, he is under no obligation to fulfill the option and can trade his dollars at the more advantageous exchange rate.

Currency Options as an Investment

In addition to their obvious practicality in international business arrangements, currency options trading has also been used as a form of Forex investment.  Someone who expects the exchange rate to move greatly may buy a currency option instead of investing his money directly.  If the rate moves greatly he can exercise his option and then trade right back at the current rate, netting a nice profit.  The important thing to consider in such investment is that the investor has only really made money if his profit is greater than the initial cost of the contract.

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