Forex (foreign exchanges) and options contracts are two of the most complicated asset classes on the market. While the explosion of low-cost trading platforms has democratized access to these product, they haven’t become any easier to understand or less risky for the retail trader. That doesn’t mean you should avoid them. Options in particular can offer strong diversification to a portfolio when used well. But it does mean that retail investors should approach with caution. Here’s what you need to know about how these two asset classes stack up. Consider working with a financial advisor as you explore higher risk investments.
Forex vs. Options: What Are They?
In some ways it’s difficult to compare forex and options trading, because these are very different types of assets.
Foreign exchanges, or “forex,” is when you swap foreign currencies against each other. Unlike with some asset classes, this is not a representative transaction. (That is to say, you are not swapping the value of a euro against the value of a British pound.) You literally exchange an amount of currency, receive an amount of foreign currency in exchange and then hold that in your brokerage account until you’re ready to make another trade.
Each currency in the world fluctuates in value against one another based on the needs of its underlying economy. For example, if companies in America want to do more business or make more investments in the Euro Zone, those businesses would need to trade their dollars for euros in order to make those transactions. This increase the value of the euro relative to the dollar as demand shifts between those two currencies. (Readers should note that this is not the same thing as inflation, although the two concepts are related.)
A forex trader tries to make money off of these currency fluctuations. The investor tries to make trades for currencies that have increased in value relative to one another. In some cases this means elaborate exchanges involving many different currencies to maximize market value. In other cases, an investor will simply trade the same two currencies back and forth based on market fluctuations.
For example, say the value of the U.S. dollar/euro was trading at 1/1.10. This meant if you swap $1.00 U.S. you will receive 1.10 euro. As an investor you might exchange $1,000 U.S. for 1,100 euros. Then say that the value fluctuates. The U.S. dollar/euro goes to 1/1.08. If you swap $1.00 U.S. you will receive 1.08 euro. Or if you exchange 0.925 euros you will receive $1 U.S. We swap our euros back for dollars and receive $1,018 U.S. That, in a nutshell, is forex trading.
An options contract is what’s known as a “derivative,” because its value derives from the value of some other asset on the marketplace. With options you trade on the value of various assets, ranging from stocks and securities to commodities, cryptocurrency and virtually any other marketable asset. However unlike with forex, options contracts rarely (if ever) actually trade the underlying assets themselves. Instead a standard option simply takes its value from the asset that it’s based on.
The most essential element to an options contract is that it gives you the right but not the obligation to make this transaction. If your contract is unprofitable, you can simply walk away from it.
As its name suggests, an option contract is a contract to buy or sell some asset for an agreed-upon price at an agreed-upon date. Call contracts are options where the person who buys the contract gets the right to buy the underlying asset. Put contracts give the person who buys the contract the right to sell that underlying asset.
For example, you might buy the following contract: Call contract, XYZ Co. stock, $20, January 1. This contract would give you the right to buy XYZ Co. stock from the person who sold you this contract on January 1 for $20 per share.
An options trader tries to make money off future market fluctuations. Someone who buys a call contract makes money if the price of their asset goes up past their agreed-upon price, since this means they can buy that asset for less than it’s worth. Someone who buys a put contract makes money if prices drop, since they can sell that asset for more than it’s worth. (If you sell a call or put contract, your position is reversed.) These contracts are entirely about trying to predict the market and its volatility.
As suggested above most options contracts are settled “on a cash basis.” This means that you don’t actually exchange the assets on which the contract is based, just the cash value of what that transaction would be worth.
Forex vs. Options In Your Portfolio
Options and forex are both highly speculative asset classes. Forex may be one of the most speculative asset classes on the market, while options are not far behind. To the extent that you trade either asset, you should do so with the segment of your portfolio that is set aside for speculative, higher-risk trading.
A good rule of thumb would be to approach options as moderately more speculative than trading individual stocks, while forex should be approached with extreme caution if at all. For the retail investor, perhaps the two most important distinctions between options and forex trading are speed and complexity.
The forex market is one of the fastest-moving markets in modern finance. Forex investors rarely hold positions open past a few hours, and most make their trades far more quickly than that. It is so rare to hold positions overnight that most, if not all, brokerages charge an additional holding fee for doing so.
The options market generally moves more quickly than most other major asset classes. Investors in this market will typically move in a matter of months, sometimes less. It is not uncommon for options traders to open and close a position within weeks or days. While this is not the twitch-trading of the forex market, it is much faster than the years that many investors will spend holding individual equities and funds.
As with speed, the forex markets are some of the most technically complex in the world. The factors that cause currencies to shift against each other encompass literally the entire world economy, and even most economists don’t always understand what makes one currency jump against another. This is a highly technical trading environment based almost entirely on data, and traders generally open and close their positions on pennies or fractions of a cent. The upshot is that this is also an extremely high-volume market, where you need to trade large sums to make meaningful profits.
The options market is very complex, and many investors get themselves in trouble thinking otherwise. In fact the most dangerous part of this market is the belief that the “optional” nature of this asset makes it zero-risk. It is anything but. However options do trade against underlying assets, which means that you can engage in robust fundamental trading as well as technical trading. This makes options a far more approachable asset class than forex, particularly for retail investors looking to add some diversity and speculation to their portfolio.
Forex is the market for trading foreign currencies against each other. It is fast paced, extremely technical and extremely risky for retail investors. Options contracts are derivatives that are based on the value of underlying assets. While also technical and speculative, you can engage in better fundamental analysis with the options market so long as you’re careful with your money.
Tips on Investing
- Forex might be technical and risky, but it is also interesting. This is literally the market that makes the world work. Even if you’ve never made a single currency swap, the forex market still lets you buy Etsy products from Canada, cars from Sweden and take vacations in Brazil. Here’s how.
- A financial advisor can offer valuable insight and guidance as you explore high-risk investing. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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