FX Option Pricing
Before I tell you what call and put options are, I have to explain a little about currency options.
What exactly are currency options? It all begins when a buyer and seller create a contract where the buyer of the option gains the right to buy or sell a fixed amount of the underlying currency at a specified price on or before the expiration date.
However, the buyer may or may not purchase or sell it.
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Call and Put Options Explained
To better understand currency options, we must know what elements they contain. First is the premium or the amount the buyer pays the seller.
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Second, there is the predetermined price also termed as the exercise price or strike price. Of course, all currency has its market value which is referred to as its spot price.
Finally, there is the expiration date of the contract. If the buyer does not exercise the option by the expiration date, then he loses the premium to the seller.
Furthermore, it is essential to know about the two basic types of currency options. The buyer’s right to buy this currency at the strike price is known as the call option.
From the buyer’s standpoint, he expects the strike price to rise, but the seller expects it to fall. Once the buyer is able to buy the currency for more than its spot price (market value), the buyer will then exercise the call option.
Next, is the put option which allows the buyer to sell the currency at the strike price. Now the buyer is hoping that its market value will fall while the seller anticipates it to rise. It is then the buyer will exercise the put option when the spot price is less than the strike price.
Once a trader has established a currency call option, this person is able to purchase a given amount of currency for a specified price.
For example, a call option may entitle the trader to purchase 300 JPY for $200 USD until the date this option expires.
On the other hand, a put option entitles the holder to sell a given amount of currency for a certain price. Thus, for instance, a trader can resell 400 EU for $200 USD during the life of the option.
CALL OPTION: buyer buys currency at strike price spot price > strike price
Call Option Example
For example, if a security is trading for $50 but you anticipate that it will go up to $60, you can buy a $55 call option for 20 cents.
If the security rose to $60, you still can buy it at $55 even though it’s valued at $60, netting you a $4.80 profit per share.
Likewise, the person that sold you the “call” would be obligated to sell you the security at $55 at a loss of $4.80.
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If the security never rises above $55 by the expiration date, the “call” expires as worthless and the “call” buyer is out 20 cents and the “call” seller keeps the 20 cents.
PUT OPTION: buyer sells currency at strike price strike price > spot price
Put Option Example
Now let’s assume that a security is trading for $50, but you believe it will go down to $40.
You then could buy a $45 “put” option for 20 cents. If the security actually dropped to $40, this would enable you to sell the security at $45 even though it’s valued at $40, netting you $4.80 a profit on each share.
Likewise, the person that sold you the “put” option would be obligated to buy the security from you at $45 and absorb a $4.80 loss. If the security never went below $45 by the expiration date, the “put” expires worthless and the “put” buyer is out 20 cents as the “put” seller keeps the 20 cents.
Making Currency Gains
The following are two simple tips to remember to ensure gains with currency option trades:
- As for the money options, purchase in or at them whenever possible.
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The greater difference between the strike price and the spot price means the less likelihood the there will be gains on this trade.
- The further away the expiration date, the better.
The closer the ending date of the option gets, the faster time goes.
Likewise, the option premium will be more likely to decay as the end gets near.
Hence, the main key in trading options is to have time on your side, even if the option costs are higher than those of say a week or less.
Does this sound simple enough?
Now that you understand call and put options, you have even more power to trade on the stock or currency market. However, before exercising either option, do your research and don’t go overboard on trading. Consider options that have one month or possibly two until expiration.