Why Vanilla Options Are Easier Than You Think

When you’re just starting out as a forex trader, you probably stick to trading basic pairs such as EUR/USD and GBP/USD on the spot market. However, as you become a bit more experienced, you’re going to realize quickly that trading vanilla options may have a lot of advantages. There are lots of more complex derivatives, but vanilla options are easy to understand and may offer good profit opportunities.

What is a vanilla option?

A vanilla option is relatively straightforward. It gives you the right to buy or sell a currency pair at a predefined price in the future. This is known as the strike price. However, you don’t need to wait until the option expires before buying or selling. For example, if you buy a call option that expires in six months, and if the currency pair price rises (as will the value of that option), you will be able to sell the option at any time before it expires to lock in your profit.

Portfolio diversification

Vanilla options are available for a large number of currency pairs, not just major currencies. For example, you could trade USD/MXN or USD/SGD, giving your exposure to performance of the Mexican or Singaporean currencies. You may also use forex options to limit your risk – for example, if you take a large position in EUR/USD, you may balance this out by buying an option in the opposite direction. Since you pay a lot less of for the option than you do for the currency pair position, then you have the opportunity to limit your losses if the pair moves in the wrong direction. On the other hand, if the currency pair moves in the direction that you expect, you’re only paying up a small extra amount to protect your investment. Think of this as insurance.

Your risk is limited

If you buy a call or put vanilla option, this gives you the right to buy or sell at the strike price. However, you’re not obligated to sell, which means that your risk is limited. The way vanilla options work is this – the value of the option is the difference between the strike price and the current price, but there is also an additional premium that you pay that is related to the time of the option’s expiry date. This means that at worst, your risk is the premium – which is a relatively small amount. However, if you sell an option, then you need to be careful – in this case, the buyer might exercise the option and obligate you to sell – in which case your risk is much higher.

Options offer high leverage

Options may also give you higher leverage than you would get if you just bought or sold a currency pair. The cost of buying an option is related to the difference between the currency pair price and the strike price – rather than the absolute price of the currency pair. Since the difference is smaller than the total cost, you get greater leverage – which means that your profit opportunities may be greater.

Risk warning: Forward Rate Agreements, Options and CFDs (OTC Trading) are leveraged products that carry a substantial risk of loss up to your invested capital and may not be suitable for everyone. Please ensure that you understand fully the risks involved and do not invest money you cannot afford to lose. Our group of companies through its subsidiaries is licensed by the Cyprus Securities & Exchange Commission (Easy Forex Trading Ltd- CySEC, License Number 079/07), which has been passported in the European Union through the MiFID Directive and in Australia by ASIC (Easy Markets Pty Ltd -AFS license No. 246566).

This article is a guest blog written by easy-forex