Have you heard about vanilla options with regard to forex trading and wondered what they were, and why so many people seem to rave about them? If so, you’re like many foreign exchange buffs who have so far only dealt with the spot market and not even considered options. Maybe you thought they were too complex, or overheard rumors about how risks are abnormally high. There’s a grain of truth to each point, but only a grain. Vanilla options (VO’s) are indeed more complicated that standard forex trading but not much more so. Secondly, risks are higher, but with that additional risk comes a much higher potential profit. What are VO’s and how do they work? Here’s a short overview of the main concepts involved.
Definition
Everything begins with two willing parties to a transaction. In a typical VO scenario, there’s one buyer and one seller. When you act as the buyer, you have the right to purchase or sell a single, designated currency in exchange for a different designated currency for an agreed-to rate of exchange on a fixed date sometime in the future. Additionally, you, as the buyer of the option, must pay a premium to enter into the transaction. Note that there are dozens of kinds of options, vanilla being the simplest of the category. The word vanilla is often used in the financial world to indicate that an instrument is the basic form of its representative class, and that’s the case here as well.
Mechanics of VO’s
When you decide to purchase a VO, most of the key decisions are in your control, except for the premium amount. For instance, if you choose to buy a VO, you tell the broker, or seller, which currency pair you want to deal with, the strike rate, notional amount, and expiration date you prefer. The seller will then calculate the amount of the premium and offer you the chance to complete the transaction. Most platforms require you, the buyer, to pay the premium within a specified amount of time, typically two business days. There are other time frames if you opt for a premium payment that is deferred, where this choice is available. Always ask your dealer or brokerage platform desk whether they offer deferred premiums. Some do and some don’t.
After that, the rest of the process is rather simple. Then the expiration date arrives, you’ll decide to do one of two things: let the contract expire as worthless or exercise your agreed-upon right to make the currency transaction. If all goes well, you’ll make the transaction and come out far enough ahead to cover your premium payment and pocket a handsome profit as well. Note that if you indeed exercise the VO, you and the seller have two business days from expiration to complete the deal.
For traders who have experience with stock options, the process is virtually the same. What makes these transactions different from a spot trade is timing. In forex, most beginners only do spot trades, which is an excellent way to learn about the market, gain an understanding about how to place orders, and see how the international currency market operates. After you get some experience with all the fundamentals, it’s possible you’ll want to delve into the VO niche where there’s a potential for greater profits, which of course come with a higher level of risk.
Complexity
While it’s true that VO’s are more complicated that spot forex trading, they can be more satisfying in terms of the risk-reward ratio. The concept of complexity is important to comprehend because VO’s are, by their very nature, more complicated contracts than spot trades. That’s because the idea of an option means that the holder of the contract is not being forced to exercise it, but rather has the option to do so or not.
As is the case with traditional stock options, traders can purchase or sell. Buyers have limited risk, namely the total amount of their investment plus however much the premium was. Sellers have unlimited risk because the market can rise, theoretically, to any level, but there are ways to avoid such situations via stop orders. In any case, that’s how the name option came into use, and it makes logical sense. For traders who like a bit of a challenge, and who are ready to deal with a higher level or risk and reward, then VO’s are a wise choice. Keep in mind that few investing enthusiasts do just one or the other. In fact, most forex folks enjoy doing a portion of their activity on the spot market and some on the options market.