The word ‘forex’ is an acronym of Foreign Exchange. So, the term Forex Trading is the act of exchanging or trading currencies from different countries against each other. It’s important to first understand how the currencies are represented to learn how forex option trading works.
Currency rates are represented relative to one another and are quoted in pairs e.g. USD/CHF = 1.06
Whichever currency is quoted first, is known as the ‘base’ and it is always written has a value of 1. The second number is the ‘quote’ currency and it represents the price for 1 unit of the base currency i.e. how much of one currency is needed to buy a quantity of the other. In the example above, it costs 1.06820 Swiss francs to buy 1 US dollar.
Where forex options trading becomes more interesting, is when the strength of currencies begins to change relative to one another. Continuing with the same example, there are two possible scenarios:
1)Or the US dollar becomes stronger so the quote currency rises e.g. USD/CHF = 1.07 – therefore it will take more Swiss francs to buy 1 dollar (or for each 1 US dollar, a buyer will receive more Swiss francs)
2)Or the US dollar weakens and the quote currency decreases e.g. USD/CHF =1.05 – therefore it costs less in Swiss francs to buy one US dollar (or for each US dollar you will receive less Swiss francs)
How does this generate forex trading? Different parties, be they financial institutions or individuals, buy a quantity of one currency in exchange for buying a quantity of a different currency. They speculate on the direction that the base currency will move in. As the value of the currencies fluctuate, forex trading takes place to take advantage of the change in price.
For example, if there is a currency pair EUR/GBP=0.876, then a trader may spend 100euro and get £87.60. If the euro weakens, say EUR/GBP=0.567 then the buyer can buy back his euros and receive 154.5€ back in return. He would have made a 54.50€ profit from his original investment.
Now it’s important to understand how this relates to forex option trading. A forex option is a contract, where a buyer has the right, but not the obligation, to buy or sell a currency at a set price within a specified time frame. In this respect, forex option trading is different from traditional forex trading as explained above. Traditional forex trading is when a buyer purchases or sells actual currencies. However, in forex option trading, the owner is buying the option not the currency i.e. they are entering into a contract to buy or sell currencies at a set price within a specified time frame.
Moreover, forex option is a type of binary option which means that all possible outcomes are determined when the contract is made. Whereas in our above example, the amount of profit gained in the trade was relative to the magnitude that the currency fluctuated by, in forex option trading, the amount is determined from the onset of the contract. For example, an owner may buy a Put option (see Options Trading) for £100, expiring at the end of the day, for a return of 71% on the currency pair USD/CHF currently at 1.01234.
If at the end of the day, the USD rises in value and ends up at 1.01235 or above, then the option has expired in-the-money and the owner will receive £171. He will receive the full 71% payout, regardless that the stock only moved 0.00001 points. This demonstrates the difference between trading forex options to traditional forex trading.
source: Forex Options Trading
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