Forex Options Trading vs. Spot Trading: What's The Difference?

Forex trading is one of the smartest ways investors can profit from the currency markets. Businesses can also use strategic forex trades to hedge their cross-border transactions against the risks associated with currency fluctuations and FX conversion rates. An interesting facet in the currency trading world is the difference between spot forex trading and forex options trading, which this article will attempt to provide an insight into. 

Differences between spot and options forex trading

Forex spot trading in the FX market involves the physical exchange of currency pairs on settlement. If you trade an AUD/USD forex pair in the FX spot market, you'll be expected to provide physical Australian Dollars in exchange for United States Dollars on settlement.

Forex options trading involves the writing, buying, and selling of a contract that put two parties in a contractual obligation to trade a particular amount of a currency pair at a stated exchange rate at some point in the future on a Forex options site, or through a forex broker.

A further difference between spot and options forex trading is the determination of the trading price and when the actual currencies are exchanged. The trading price of spot forex is determined at the point of trade, and the physical exchange of the currency pairs happen immediately or shortly thereafter.

In forex options, the trading price is determined at the point of trade, but the physical exchange of the actual currencies is often fixed for a future date. Interestingly, most of the traders who trade forex options are speculators; hence, many of them close out their options contract before settlement and they rarely take physical delivery of the currency pairs. Similarities between spot and options forex trading

The first similarity between spot and forex options trading is that both involve the trading of currency pairs in the forex market. Secondly, both traders involved in spot forex and forex options can record profits when there's an upside or downside change in the market. The third similarity is that both markets are focused on forecasting future changes in the value of currencies. And also, both tend to focus on short term changes in the value of currency pairs.

Case study on spot forex trading vs. forex options trading

One of the most common currency pairs in the forex market is the GBP/USD pair that trades the Great Britain Pound against the United States Dollar. The GBP has traditionally traded at a higher value than the USD but the unexpected outcome of the Brexit vote changed the narrative for the currency pair.

After the Brexit vote in which UK voted to leave the EU, the pound crashed to a 31-year low against the dollar with £1 fetching $1.37 down from $1.50 after the referendum was concluded as seen in the chart below.

GBP holders who had reasons to buy the USD in the first few days after the Brexit vote typically paid between 7% and 10% more in order to account for the weakness in the GBP. However, forex options traders who had a futures contract to buy £1 at $1.50 were able to exercise their contracts at the predetermined price even though the pound has lost 10% in the actual market.

However, spot forex traders are protected from some risks to which forex options traders are exposed. For instance, a call option obligates the holder to buy a currency pair at a given price regardless whether the currency has appreciated or depreciated by the settlement date. Put options give the holders an obligation to sell a currency pair at a given price regardless of a gain or loss in the currency at its settlement. However, smart traders use stop loss orders to limit their downside risk and exposures on forex options.

A quick word on vanilla options and binary options

If you are interested in trading forex options, you might have come across the words "vanilla options" and "binary options". Vanilla options refers to the traditional options in which you have the right to buy or sell the underlying asset at a predetermined price by a given date.

Binary options on the other hand allow traders to place trades on binary "Yes/No" propositions on the anticipated direction and magnitude of the underlying asset. In a binary options trade, traders gain a predetermined payout if they are on the right side of the trade; however, the trader will lose the entire premium paid on the trade if they happen to be on the wrong side of the trade.

Luis is a business writer and financial analyst. With over 15 years of experience in global finance and an MBA in economics and management, Luis's areas of expertise include business, marketing, communications, personal finance, macro economics, stocks and emerging markets.