If you trade in the Forex market and you're not using risk management you are sooner or later going to be out of business. No Forex trading system will do you any good without a good risk management system. For most students learning about Forex trading managing risk is all about placing stop loss orders under your trade, and this is how it ought to be, but be advised, risk management is more than just using stops. If you have ever encountered a Forex market that was so volatile that you couldn't maintain a position for very long without getting stopped out, then you know that there needs to be a more useful tool for risk management, as stop-loss orders on their own simply don't make it.
In this article we shall explore the basics of a relatively new tool that Forex currency traders can use to save their skins. This new tool is the Forex currency option contract. Euro against the dollar, but good money management practice dictates that you place a stop loss order under your trades which exposes you to getting stopped out if that market becomes more volatile.
If instead you purchased a “call option” on the EUR/USD currency pair, you would have the benefit of participating on any upward price movement that went beyond the striking price regardless of how much that is, and your total risk for that trade would be strictly limited because you paid a premium for that forex option contract. Your risk could not be any greater than the premium that you paid for the option.
This can mean a lot to you if you really want to buy the euro right now, but you are not able to because your risk management parameters do not allow you to enter the market because of a dearth of good places on the chart where stops can be placed. Options by themselves are simply contracts that give their owners the right, but not the obligation to buy or sell something of value at predetermined price for a specific period of time regardless of what the market price of that asset is. These rights provide an inexpensive way to participate in a big market move while limiting your risk to only the amount paid for the contract.
A Forex option contract gives you the right to buy (or sell) a currency pair at a predetermined “striking price” up to a certain date regardless of what the prevailing value of that pair is at any time up to the expiration date of the option. If the option contract turns out to be worthless then the holder would just abandon the option and walk away knowing that he or she has no further obligation.
If on the other hand, the currency pair in question makes a big move pushing up beyond the striking price, then the option will have real equity, and the holder can exercise it and take delivery of a currency position that is “in the money” and therefore instantly profitable. The key element to this strategy is in the limited risk associated owning the Forex option contract. Let's assume you believe that the euro is going to gain against the U.S. dollar. You can of course go long. So, as you can see, adding currency option contracts to your trader's toolbox for risk management purposes can bring about a better string of results and a more profitable equity curve.