In the world of international finance and trade, FX options and futures options are much more common than the stock options traded in by the majority of US retail traders. The FX (Forex) options market is in fact the biggest, deepest and most liquid options market in the world.
Since the majority of this FX options trading takes place over the counter (OTC) it is not heavily regulated. A small percentage of trades take place through exchanges such as the Chicago Mercantile Exchange, the Philadelphia Stock Exchange and the International
Online FX and Futures Options brokers abound nowadays. Be sure to compare the commissions, spreads and reputation of a few of these brokers before depositing any money.
Currency options (FX options) are similar to options on stocks in many ways, but there are also important differences. A currency option gives its owner the permission, but not the obligation, to buy or sell a given currency pair at a given price on a certain future date.
The important difference here is that we are dealing with a currency pair, which some traders find confusing. What follows is a brief explanation.
If a trader expects the USD/GBP exchange rate to come down between now and a certain date in the near future, he or she can buy a put option on this currency pair. Alternatively one could sell call options on the USD/GBP pair.
Conversely, if one expects the USD/GBP exchange rate to increase in the near future, one could either buy call options or sell put options on this currency pair.
Whether a trader decides to buy put/call options or sell call/put options depends on whether he or she expects the rate to move strongly up or down or only slightly. If a strong move is expected, buying put or call options is the better choice. For a smaller move selling call/put options will be a better solution.
Options on futures
Similar to currency options, it is also possible to trade in futures options. Once again a call option here gives one permission, but not the obligation to buy the futures contract at a certain price and a put option the right but not the obligation to sell it at the strike price on the expiration date.
Futures options are available on a vast variety of tradable assets, including stock indexes like the S&P 500 and commodities such as gold, oil, silver and soybeans.
With commodity options, such as those on soybeans, it is important for the trader to have at least a basic knowledge of the seasonal forces that drive that particular market. During certain times of the year there tends to be shortages in the soybean market, for example, which drives up the price. Without knowing when this is likely to happen an options trader would be at a disadvantage against someone who knows that market.
Valuation of FX options and futures options
The two models that are most often used in the valuation of both FX and futures options are the Black-Scholes model and the Garman-Kohlhagen model. As with stock options, volatility plays a major role in the valuation of these two types of options.