There are different types of fx options. While many traders still focus on traditional fx options, the evolution of the currency options market has also created some demand for exotic fx options.
Of course, we have more ways how we can classify currency options, based on the aspects which differentiate them. Let’s discuss the most common types and subcategories in the following article.
Traditional Options vs. Exotic Options
A traditional fx option, also known as a vanilla fx option, is a normal call or put option. Traditional fx options work pretty much in the same way as classic stock options. Furthermore, contracts for vanilla options are standardized when they are exchange-traded. The second important type is the class of exotic fx options. Let’s compare these two categories and understand their differences.
Traditional fx options (Vanilla options)
The class of vanilla currency options consists of two main styles of traditional fx options. Contrary to the type, the style describes when a currency option may be exercised.
- European style options: Only the price of the underlying at the expiration date is relevant. We can only exercise them with a profit if they are in the money on this specific date.
- American style options: This kind of option is more flexible and therefore more expensive. We can exercise them at any time on or before its expiry.
American options mean greater implied volatility compared to European options. The reason is that they contain much more flexibility regarding their dates of exercise.
A buyer can generate a higher average profit because he doesn’t need to wait until the date of expiration if he’s in the money. Logically, this extra flexibility comes at the expense of a higher premium.
Exotic fx options
An exotic fx option, also known as SPOT option (for “single payment options trading”), is a type of currency option that has only two outcomes.
Buyer and seller agree on a scenario, like “In the next 30 days, the EUR/USD spot rate will break 1.15”. Either the scenario happens, and the buyer wins an agreed amount, or else he has lost the premium.
There are various types of exotic fx options:
- Barrier options: When the price reaches a specific threshold, then this kind of option starts or stops to exist.
- Digital options: The buyer only receives a payoff if the underlying fx rate is above or below a specific price level at a previously agreed time.
- Asian options: The return is calculated based on the average price of the underlying fx rate during the whole lifetime of the option.
Please keep in mind that the class of exotic options features very sophisticated products.
Typically, they are only OTC-traded. Additionally, this type of fx option comes with a higher premium, and their calculation is less transparent. Therefore, retail traders in some countries can’t trade all sorts of exotic currency options right now due to legal restrictions.
Summary: We can place forex options into two main categories. The type of traditional vanilla fx options consists of the subclasses of American and European styled forex options. We can trade both of them similarly to classic stock options, with Calls and Puts. The class of exotic fx options contains the groups of Barrier, digital and Asian options.