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An important tool used by businesses to reduce the risk of trading in goods overseas and by Forex traders to hedge transactions is the currency option, which is a contract which gives the holder of the contract the right, but not the obligation, to either buy or sell a specified currency during the period of the contract. A contract giving the holder the right to buy is known as a ‘call’ option, while a contract which gives the holder the right to sell is termed a ‘put’ option.

The value of an option contract at its expiry date is the value which is realized by the holder in exercising his option at that point. If, for example, the holder would gain nothing by exercising his option then the contract would have no value and the contract would simply lapse without the holder exercising his option. The value at any other point in time, which is referred to as the contract’s ‘intrinsic value’ is the value which could be realized if the holder were to exercise his option.

The intrinsic value of a contract is based upon the ’strike price’ specified within the contract. For example, the holder of a call option (the right to buy) will have intrinsic value in his contract if the current, or spot, price of the contract currency is higher than the strike price. In other words it has value because, if he exercises his option under the contract, he can buy at the strike price which is below the current market price.

An option contract which has intrinsic value is said to be ‘in the money’, while a contract on which you would lose money be exercising your option is said to be ‘out of the money’. If you would neither gain nor lose then your contract is ‘at the money’ or ‘at par’.

The pricing of option contracts is a complicated business using a formula which looks at both the current value (spot value) of the currency and a time value, calculated on the basis of market expectations, volatility and any difference in interest rates between the two currencies specified in the contract. Remember, that a contract might give you the option to buy a currency at a certain price but it will also need to specify the currency being used to pay for the transaction. The secret in pricing an option is to set the price low enough to attract buyers, but also to set it high enough to attract sellers and guarantors for the contract, often referred to as the contract’s ‘writers’.

When it comes to Forex trading, options can be used to reduce the risk of unexpected movements in the market. In this case, if you buy and option then your losses will be limited simply to the price of the option. However, if you are selling options, then your losses can be more substantial and are potentially unlimited.

Forex trader also commonly use a special form of option known as a digital option which pays a specified sum on expiry as long as certain criteria are met and otherwise pays nothing. In using digital options traders judge the direction in which the market is moving and then decide upon a specific payout if the market moves according to their expectations within a given time frame. If that sound complicated then perhaps an example will help.

Let’s suppose that the UK pound is currently trading at 1.58 and that you expect it to be trading at 1.62 in 3 months time. You then buy a digital option which costs say $600 and has a payoff of $4,000. If at the end of 3 months the UK pound is trading above 1.62 then you receive $4,000 and if it is trading at less than 1.62 you receive nothing and lose your original investment of $600.

Currency options are just one of the many tools which the Forex currency trading beginner will find available to him and which make the Forex market one of the safest markets for novice traders.

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Forex trading is both exciting and lucrative and, since rules were changed to allow small investors to participate in the market by trading on margin accounts, it has attracted a huge number of very happy small investors who today trade at a time suit themselves from the comfort of their own homes. But Forex trading is not quite as simple as many people think and you will need to invest quite a lot of time and a little bit of money in some good training before you embark on any sort of live trading.

One of the first things that you will need, once you have acquired some basic knowledge, is a broker who will handle your transactions for you. The vast majority of brokers are reputable individuals who are associated with a major financial institution, such as a bank, and are registered, in the United States for example, as a Futures Commission Merchant (FCM) with the Commodity Futures Trading Commission (CFTC).

Having found a broker you can then open a Forex trading account by simply filling in a form and producing proof of your identity and then fund your account and start trading. When you open your account the terms under which you can trade on your account will be clearly specified and one point to note is that you will be subject to a margin agreement which will allow the broker to intervene in any trade which he considers to carry too high a risk. This is reasonable enough since when you are trading on margin you are essentially trading with the broker’s money and not your own money.

You will find that most brokers will offer a range of accounts to suit individual investors and one of these accounts is commonly referred to as a mini account which normally allows you trade with as little as $250, as opposed to the $1,000 to $2,500 usually required for a standard trading account. You will also find that leverage varies from one account to the next and from one broker to the next. Leverage simply allows you to trade with more money than you have in your account and the higher the leverage the larger the trading lots you can participate in.

Perhaps the most important thing to look for though as a novice trader is the ability to start by simply trading on paper. This means finding a broker who offers you the ability to practice trading through a simulated account until you have found your feet. Simulated accounts allow you to run trades just as if they were real and to use all of the supporting predictive, charting and trading software, but without actually placing any money at risk. You will find that many brokers will have a demo account which they will let you cut your teeth on for your first month.

Finally, make sure that your broker has all of the software tools that you need including such things as news feeds, real time quotes, charting and profit and loss calculators and that he has a reliable website which is easy to navigate, fast and has excellent backup facilities.

Many people will tell you that, after the right training, a good broker is key to the key to the success of any novice trader and a broker who will provide you with a Forex demo account and help you to get up to speed is worth his weight in gold.

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Today’s futures market can trace its origins back to the agricultural markets of the 19th century when farmers began entering into contracts to deliver agricultural products at some date in the future for a fixed price in order to stabilize supply and demand across the different seasons of the year. Today the futures market has expanded to include far more than simply agricultural products and includes not only commodities but also financial instruments such as currencies and treasury bonds.

Many of the participants in the market today are speculators rather than traders and the actual commodities or financial instruments are unimportant as it is the futures contract itself which is actually traded as it rises and falls in value over time according to the value of the underlying commodity or financial instrument.

If that sounds complicated let’s try to simplify things a little bit by looking at an example using an agricultural commodity. Suppose a farmer is supplying wheat to a baker and agrees to sell him 100 bushels of wheat at $6 a bushel with delivery being set for some specified future date. If the price of wheat were to remain constant then on the specified date the farmer would simply deliver the wheat and would then be paid $600. However, the price of wheat is unlikely to remain constant and indeed is quite likely to change on a daily basis and this is where the futures contract for this particular transaction comes into play as it is valued at the end of each day in the period between the date on which it was drawn up and the date on which the wheat is finally delivered.

So, let’s assume that on the day after the contract is drawn up the price of wheat falls to $5 a bushel. At the close of business on this day the farmer’s account would be credited with $100 ($6 - $5 x 100 bushels) and the baker’s account would be debited with the same amount. Similar payments would then continue to be made back and forth between the two accounts as the price of wheat rises and falls each day until delivery is effected and the final payment is made as originally agreed.

So where is the benefit to the farmer and the baker? Well, let’s assume that the price of wheat fell as shown above by $1 a bushel the day after the contract was drawn and then remained steady throughout the rest of the period. On settlement day therefore the price of 100 bushels of wheat on the open market is $500. At this point the farmer has made $100 on the contract and the baker has lost $100. However, because the baker can now buy 100 bushels of wheat on the open market for just $500 he does so and, together with the $100 he has lost on the contract ends up paying the price he had originally intended to pay of $600. Similarly, the farmer now has to sell his wheat on the open market at a loss of $100 but, since he has already made $100 on the contract he is no worse off and still ends up getting $600 for his wheat.

In this case the baker has lost out paying $100 more than he needed to for his wheat but has nonetheless managed to buy it at a price which he had originally budgeted for. What he has done however is to protect himself from the possibility of a rising market. For example, had the price of wheat risen to $8 a bushel, without a futures contract, he would have had to pay $800 on the open market.

Speculators working in the futures market buy and sell futures contracts in the hope of profiting from the daily fluctuations in the values of those contracts. For example, a speculator will buy a contract from the buyer if he expects prices to rise (buying long) and will buy a contract from the seller if he expects prices to fall (buying short).

The futures market is a complex market and one problem with the market is that it is governed by the law of supply and demand which means that it is not always as easy as you might like to either buy or sell futures contracts. This is particularly true of some sectors of the market in which supply and demand can be generally quite low and also fluctuate significantly.

By contrast the Forex market is the world’s largest and most liquid financial market and the one market in which the law of supply and demand really does not apply. Open 24 hours a day 7 days a week (in contrast to most futures markets which are open for just 7 hours each day) there are always opportunities open to buy and sell the world’s major currencies.

As if this were not enough, Forex transactions are commission-free with brokers earning their money on the spread in the price between buying and selling currencies. These spreads too are the lowest you will find in any financial market.

If you are tempted to look to the futures market as an investment vehicle to make your fortune then, before you do so, take a moment to consider the Forex as an alternative. Many millions of small investors are committing themselves to learn Forex every day and, with the small capital investment required to enter the world of Forex trading, are finding that it is one of the smartest decisions they have ever made. 

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