Is Trading Currency Options Risky?

Are currency options risky? Well, that’s a yes and a no. While options of all types are considered to be higher risk than other financial instruments, it does not mean they are inherently risky. It all boils down to how you define risk.

Commonly, risk is defined by the volatility of a particular instrument. Bonds, for example, are very slow to move in price, and as such they are considered a very low risk investment. Stocks are in the intermediate, as they change in price faster than bonds and at a greater degree, but are still very solid, long-term investment candidates. Currencies are relatively low-risk if unleveraged, but extremely high-risk when coupled with greater amount of leverage.

Options are considered high-risk because they are derivative instruments; that is, they are not a stock, a bond, or a currency, but the option to buy that particular stock, bond or currency. Since the option is actually an option to buy the currency, it can rise higher and faster than can the currency itself. It is essentially a high leverage bet on a currency, and with that comes a high degree of individual investment risk.

Rethinking Leverage
Just because options can rise and fall in large steps, often by as much as 10-20% per day on the front-month contracts, doesn’t mean they are inherently detrimental to your portfolio. In fact, currency options can be traded in a way that is actually less risky than simple currencies.

Let’s take for example a currency option with an inherent leverage amount of 10:1. This currency option would rise 10 times more than a currency, and fall ten times more than the currency falls. If you were to buy this contract, your account balance could shift by 10% per day on a 1% change in the underlying currency. However, this isn’t how it has to be.

You see, how much you invest in each trade is as important as what you are trading in the first place. If you instead invested only 10% of your account balance into the above option, each 1% change in the value of the underlying currency would bring a 1% change in your account balance. However, the value of the option itself would have changed 10%. See?

Because you greatly reduced the percentage of your account that you were willing to stake on an individual trade, you have minimized the total impact of the currency option to your portfolio, regardless of how volatile the option is from hour to hour, or even minute-to-minute. You stand to lose now only 10% of your total account balance.

Why you should maximize leverage
Most investors look to maximize their leverage while reducing their total exposure for one very simple reason: interest rates. We’ll use an example to demonstrate this point:

Investor A has a $100,000 account. He buys a currency option with an implied multiple of 10:1 in an amount of $10,000. Thus, 10% of his account is invested at 10:1, while 90% of his account remains in cash.

Investor B has a $100,000 account. He buys a currency option that has an implied multiple of 100:1, but unlike Investor A, Investor B invests only $1,000. Thus, 1% of his account is invested at 100:1, while 99% of his account remains in cash.

Many people falsely believe that the two should have returns that are equal. This is not the case. Since investor B has $99,000 in unallocated cash in his account, he earns interest on $99,000. Investor A, however, has only $90,000 in cash, and earns a flat interest rate only $90,000. The difference, especially over the long term, can be staggering, and it is the reason why you should always seek to use the highest amount of leverage possible, even if it means exploring a currency option where you might have previously purchased currency with leverage only.

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