Options are an important financial tool used to manage the risk in some investments, such as in stock and currency trading. Anyone responsible for managing investment risks should have a thorough working knowledge of options. At the most basic level, currency options are a choice. When an option is purchased, the buyer is purchasing the right to buy or sell an asset if certain conditions in the market are present. This is in contrast to having an obligation to buy or sell. With an option, the holder has a choice as to whether or not to exercise the right to buy or sell.
Buyer – The person or entity who buys an option. The buyer is also known as the option holder.
Call – A type of option where the buyer obtains the right to buy a specific currency at a rate specified in the option. When option holders exercise this right, they are said to “go long.” This puts the buyer into a long currency position. Conversely, the seller of the option is put into a short currency position.
Exercise – The action an option holder takes when they intend to reach a position in the option currency at the strike price.
Expiration – Options are only good for a specific period of time. The expiration date is determined at the time of transaction. There are two specific types of expiration, American options allow for the option to be exercised at any time before the expiration. European options only allow for the option to be exercised on the expiration date.
Premium – The purchase price of the option. The money the buyer gives to the seller of the option. This represents the maximum amount of money a buyer can lose on the underlying.
Put – A type of option where the buyer obtains the right to sell a specific currency. When option holders exercise this right, they are said to “go short.” The seller is put into a long currency position from the transaction, and the buyer is put into a short currency position.
Seller – The person or entity who sells an option. The seller is also known as the grantor or option writer.
Strike price – The rate at which a call buyer has a right to purchase an underlying currency, or the rate at which a put buyer has a right to sell an underlying currency. The strike price, also known as the exercise price, is determinate when the option is initially purchased.
Underlying – The specific currency attached to a particular currency option. The option gives the buyer the right to buy or sell only this currency.
Before an option is purchased, it is necessary to determine what an option is worth at the time of expiration. This value is a reflection of the amount of money that can be made by exercising the option. If no money can be made by exercising the option, then the option is worthless.
Intrinsic value – The amount of money that can be made at the present time by exercising an option. Call options have an intrinsic value with the strike price is less than the exchange rate. Put options have an intrinsic value when the strike price is more than the exchange rate.
In-the-money – An option with intrinsic value.
At-the-money – This is when the strike price of an option is the same as the exchange rate. Since they are the same, no benefit is yielded by exercising the option, so it is allowed to expire.
Out-of-the-money – This is when the exchange rate for an underlying currency is such so that money would be lost if exercising the option rather than trading the underlying at the exchange rate. A call option is out-of-the-money when the exchange rate is less than the strike price. A put option is out-of-the-money when the exchange rate is more than the strike price. Out-of-the-money options have no intrinsic value, so they are allowed to expire unexercised.
A currency option provides the holder the right to buy or sell an underlying covered currency for another specified currency at a rate specified in the option on or before the predetermined expiration date. The right to buy is given in a call option, and the right to sell is given in a put option. At no time is the option holder obligated to exercise the rights granted by the option.
A currency option always involves two distinct parties: the buyer and the seller. Buyers are also known as holders, and sellers are often called writers. The option buyer purchases the option from the seller at a negotiated price known as the premium. Upon the transaction, the seller is extending a commitment to the buyer to sell or buy the specified underlying currency upon demand anytime before the expiration of the option.
The rate at which the underlying currency is bought or sold upon exercising the option, is explicitly stated in the terms of the option. This rate is called the strike price or the exercise price. The option may use one of two means to quote terms. One of the two currencies in the option is expressed as a value of the other. For example, Australian dollars per unit of foreign currency. Some options use the inverse, foreign currency per Australian dollar. For options regarding two foreign currencies, the option will express the terms used. The complete terms of an option are composed of the following parts:
An option that grants the holder the right to buy an underlying currency is a call option. An option that grants the holder the right to sell an underlying currency is a put option. American-style options allow the buyer the right to exercise the option at any date before the expiration date. European-style options only allow the buyer the right to exercise the option on the expiration date.
The premium negotiated in the purchase of an option is a representation of what both parties deem is the current value of the option. Current value is comprised of intrinsic value and time value. Intrinsic value is the difference between the exchange spot price and the exercise price. Put options have intrinsic value when the strike price is greater than the spot price. Call options have intrinsic value when the strike price is lower than the spot price. Any option with intrinsic value is an option that is in-the-money.
When options are purchased, the premium may be more than the intrinsic value because of time value. Five variables go into determining an option’s time value:
As the expiration approaches, the time value diminishes. If an option has no intrinsic value, but only time value, the option is out-of-the-money.
Several different pricing models for options have been developed over the years. The three most popular models for options pricing are Black-Scholes, Cox-Rubinstein, and Garmin-Kohlhagen. These models are all very complex and numerous texts are devoted to their explanation. The differences in interest rates and the effects of supply and demand can also play a large part in option pricing.