Issue #49: Thursday, March 26, 2009

The New Dollar-Denominated Options

By Kat Von Rohr As I said yesterday, there are countless ways to capitalize on the all the advantages the “Forex” market offers…even if you have no interest in trading currencies in the Forex market itself.

Take currency options for example. A currency option is simply a contract that gives you the right to buy (or sell) a particular currency at a specific price (by a certain date).

Now currency options are really nothing new to the investment scene. In fact, currency options and options on currency futures have been available for quite some time.

But in mid-2007, the Philadelphia Stock Exchange (now known as the NASDAQ OMX) changed the whole landscape with a new brand of currency options that opened up this already lucrative market to even more retail investors.

The “Stock-Like” Currency Options

At the time, the thinking was that if you could trade stock options, you could trade these new currency options. And more importantly – any broker who could trade regular stock options, could trade these new-and-improved currency options..

The PHLX designed these new currency options so they mirrored all the aspects of stock options. Like stock options, they have expiration dates, they trade during standard trading hours, and with contract sizes that are small enough for the retail investor.

These options are all also settled in dollars. So when you close out a currency options contract, you receive dollars back on any gains rather than cash back in foreign currencies.

Today, almost two years later, you can easily make directional bets on six different currencies against the buck through your normal stockbroker.

• Euro (XDE)
• Japanese Yen (XDN)
• British Pound (XDB)
• Swiss Franc (XDS)
• Canadian Dollar (XDC)
• Australian Dollar (XDA)

If you believe a currency will rise against the dollar, you buy what’s called a call option. If you believe a currency will sink, you buy a put option.

Of course, other types of options are available including paired currency trades like straddles and strangles. Straddles are positions that include both one put and one call option. They both have the same underlying currency, the same expiration date, and the same strike price. Strangles are similar to straddles only they have different strike prices.

But if you’re a new investor to options, I recommend sticking to the basics – puts and calls.

The Nitty-Gritty: How FX Options Differ from FX Trades

There are countless ways that FX options differ from regular FX trades, but they have one important thing in common…

Both Forex trades and Forex option trades are leveraged investments. In other words, both types of trades give you the opportunity to earn higher gains in quicker timeframes. But as with most investments, the opportunity to earn quicker, larger gains means these are higher-risk trades. So you should NOT be investing the long-term conservative part of your portfolio in either market.

Okay, that caveat firmly out of the way…here are a few of the important differences.

1. Type of Account Needed: To trade in the spot Forex market, you need a special Forex trading account. It’s not hard to set up, but it is separate from your normal brokerage account. As I said before, you should be able trade PHLX currency options through any standard stockbroker. (I say “should” because you need a stock broker who can handle regular stock options. Ask your broker for details.)
2. Forex vs. Option Language: When you start investing in the Forex market you have a new trading language to learn. You have to become comfortable with pips, lots, currency pairs, etc. In contrast, currency options use the same trading language as regular stock options, so if you’re already familiar with stock options, you’ll already “speak the trading language” for these currency options.
3. Number of Possible Trades: The Forex market allows you to pair currencies all around the world to create dozens of possible trading pairs. But currency options are a bit simpler – you only have six choices for currency contracts (at least for the new brand of currency options on the PHLX).
4. Expiration Times: Like stock options, currency options are wasting assets. When you buy an option, you’re buying the time for the market to move in the direction you expect. This means they have expiration dates, and they lose their value as you get closer to their expiration date. In contrast, Forex trades never expire.
5. Liquidity: The Forex market has the reputation of being the most liquid market in the world, which means you can usually get in and out of most trades easily. In contrast, currency options occasionally have poor liquidity (one of their key disadvantages).
6. Risk Used: For options, you only ever risk the cost of each individual option contract. You pay what’s called a premium – and that’s the most you can ever lose on any one currency options contract. In the spot Forex market, you can use considerable leverage on each trade. And if the trade doesn’t go your way, you have to have a risk-management plan in place (i.e., a stop-loss/trailing stop, etc.) to protect your trading account. You can NOT simply let your Forex trade expire and lose your initial investment like you can with options.

Bottom line: There are plenty of ways out there to invest in currencies – even if you have no intention of Forex trading. Tomorrow, my colleague Sean Hyman will tell you how to use some of these strategies to rebuild your retirement plan with foreign currencies.

EDITOR’S NOTE: Not sure what type of currency investing is right for you? Our new currency course, Cracking the Currency Vault includes a special quiz to help you decide which currency investment vehicle is right for you. Click here for full details on this breakthrough course.

Kat Von Rohr is the managing editor of World Currency Watch, and the co-editor of FX University and Currency Capitalist.