SPOT Options: Advantages and Disadvantages

Single Payment Options Trading (SPOT) options are unique because they automatically exercise an option on behalf of a trader if a certain scenario occurs. With a traditional options contract, there is a strike price and an expiration date. An individual holding the option can exercise the option if he or she chooses at the strike price or at the expiration date. In either case, the individual holding the option has to actively choose whether to exercise it. With a SPOT option, this occurs automatically.

Terms and Definitions

To understand SPOT options, it is first necessary to understand a few terms. One key term is "strike price." This is the ideal price when the individual who holds the option would have the option to execute the option. The option can be executed when it hits this price, or it may be executed at the "expiration date." The expiration date on an option is the day the contract is no longer binding. Finally, an important term used in options is "premium." This is the cost the purchaser pays just to hold the option. If the option goes un-executed, the purchaser forfeits the premium.

Foreign Exchange SPOT Options

It is important to understand that SPOT options are used primarily in foreign exchange (forex) trading. A trader picks a scenario based on his or her own analysis. For example, the trader may think the euro to US dollar exchange rate will be 1.25 within the next two weeks, but he or she cannot say when. The trader can purchase a SPOT option with a two-week expiration date at the 1.25 strike price. The trader pays a premium to obtain the options contract. If the strike price occurs anytime before the option contract's expiration date, the trader receives a payout based on the terms of the contract.

Example

Two traders believe the euro to USD exchange rate will be 1.25 within the next two weeks. In one scenario, a trader purchases a put option to sell 100euro for $150USD at any time within the next 14 days. If the strike price is reached, he will execute the contract. He purchases the 100euro for $125USD and sells them for $150USD, making a $25 profit.

The second trader uses a SPOT option contract. She purchases the option at 1.25 with a 14-day expiration. The terms of her contract guarantee a $40USD payout if she is correct. When the option strikes, the trader receives her $40 based on the terms of her contract.

Benefits and Downsides of a SPOT Option

The main benefit of a SPOT option is its simplicity and automation. A trader does not have to execute a trade in order to execute the option. Instead, the premium is paid, and the reward is given if the trader is correct. In exchange for this ease, though, the premiums on SPOT options are much higher than those on traditional options models. If a trader guesses right on an exchange rate, he or she will make more from most traditional options contracts than on similar SPOT contracts because the premium is lower.

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