Insurance

Following our previous discussion on call option in forex options trading, now let's discuss about put option. In forex options contract, put option gives a right, but not an obligation, to a trader to sell a certain currency at a certain price within a certain time period.

When you have a nice view on a currency, let's say GBP/USD, you are 90% sure that GBP/USD will go south within the next 14 trading days, you can purchase a right to sell GBP/USD from someone who sells put option.

Here is an illustration to help you out grabbing the basic concept of put option in forex options trading:

Today, the value of pound sterling against US dollar is 1.5000. After you analyzed your chart thoroughly, you can view there is a good probability for GBP/USD to go downwards within 5 trading days. You then buy a put option at a certain strike price, let's say 1.4800 (200 pips below current price). Your broker sets the premium (option cost) price at 5 pips US dollar.

Afterward the market, as you have predicted, moves within a tight range for several days and in the fourth day after you bought a put option GBP/USD finally goes lower to 1.4700. Done! If you decide to exercise your put option at 1.4700, or at any price, then your trade in forex options trading is done.

On the above illustration you will bring home your profit 90 pips. This profit is gained from 1.4800 (the strike price you got) subtracted by 1.4700 (current price) and the result is again subtracted by 0.0010 (the premium). You can see that the calculation is so simple.

In other business sector you can also find out similar situation. For example, when you want to buy insurance for your car which its value is $10,000, the insurance company will ask for you a certain amount of premium, say $1,000 for 5 year all-risk insurance. When there is nothing happen to your car, you can't ask for the premium as it goes to the insurance company. But if something you don't expect happens to your car, you can have a new car for only $1,000. Have you got the idea?

Now you can have the basic concept of put option in forex options trading. Actually, the concept is the same as you can have in stock options trading. The difference is only the underlying asset.