Options

Speculation is an attempt to profit by trading on expectations about prices in the future. In the foreign exchange markets, speculator take an open (unhedeged) position in a foreign currency and then close that position after the exchange rate move in the expected direction. Speculating in Option Markets The option owner has the choce of exercising the option or allowing to expires unused. The owner will exercise it only when exercising is profitable, which mean only when the option is in the money. In the case of a call option, as the spot price of the underlying currency moves up, the holder has the possibility of unlimited profit. On the down side, however, he holder can abandon the option and walk away with a loss never greater than the premium paid.

Hans is an investor. He purchases an August Call Option on Swiss francs with a strike price of 58.5 ($0.5850/SF), and a premium of $0.005/SF. At all spot rate beloww the strike price of 58.5, Hans would choose not to exercise his option. This is because at spot rate below the strike price of 58.5, he would prefer to buy a Swiss franc on the spot market rather than exercising his option to buy a Swiss franc at $0.585/SF. If the spot rate remains below the strike prices until August when the option expired, Hans would not exercise the option. His total loss would be limited to only waht he paid for the option, the $0.005/SF purchase price. At any lower price for the Swiss fran, his loss would be limieted to the original $0.005/SF premium paid for the call option. But, at all spot rates above the strike price of 58.5, Hans would exercise the option, paying only the strike price for each Swiss franc. That is, if the spot price were higher than strike price at maturity, he would exercise his call option, buying Swiss francs for $0.585/SF (strike price) instead buying them on the spot market at a higher price. He would sell immediately the Swiss francs in the spot market, pocketing a gross profit of $0.010 or a net profi of $0.005/SF after deduction the original cost of the option of $0.005/SF.

Hans profit, if the spot rate is greater than the strike price, with strike price $0.585, a premium of $0.005, and a spot rate of $0.595 is Profit/Loss = Spot Rate-(Strike Price + Premium) = $0.595/SF ($0.585/SF + $0.005/SF) = $0.005/SF More likely, Hans would realice the profit by executing and offeseting contract on the options exchange rather than taking delivery of the currency. As an option holder, Hans faces a limited loss and potential unlimited-profits. Break-even price is he the price at wich an option holder neither gains or loses on exercise of the option, but he will still exercise the call option at the breake-even price. This is so as by exercising it the option buyer at least recovers the premium paid for the option. At any spot price above the exercise price but below the breake-even price, the gross profit earned on exercising the option and selling the foreing currency covers part (but not all) of the premium paid.

WRITER OF A CALL

The position of the writer (seller) of the same call is now explained. If the option expires when the spot price of the foreign currency is below the exercise price of 58.5, the option holder does not exercise. What the holder loses, the writer gains. The writer keeps as profit the entire premium paid of $ 0.005/SF. Above the exercise price of 58.5, the writer of the call must deliver the foreign currency for $0.585/Sf at a time when the value of the Swiss franc is above $0.585. If the writer sold the option naked, thatis, without owning the currency, the writer will now have to buy the currency at spot and take the loss. The amount of such a loss is unlimited and increases as the price of the foreign currency rises. Once again, what the holder gains, the writer loses. Even if the writer already owns the currency, the writer will experience and opportunity loss as the foreign currency could have been sold for more in the spot marketThe profit to the writer of a call option of strike price $0.585, premium $0.005, an d a spot rate of $0.595/SF is: Profit = Premium (Spot Rate Strike Price) = $0.005/SF ($0.595/SF-$0.585/SF) = - $0.005/SF But only if the spot rate is greter or equal to the strike rate. At spot rates less than the strike price, the option will expire worth and the writer of the call option will keep the premium earned. The maximum profit that the writer of the call option can make is limited to the premium.

B uyer of a PUT

Hans position as as buyer of a put is now explained. The basic terms of this put are similar to those we just used to illustracte call. The buyer of a put option, however, want to be able to sell the foreign currency at the exercis price at the strike price when the market price of that currency drop (not rises as in the case of a call option). If the spot price of a franc drops below the strike price, Hans will deliver francs to the writer and receive $0.585/SF. The francs can now be purchased on the spot market for less than the strike price of $0.585/SF. The profit to the holder of a put option if the spot rate is less than the strike price, with a strike price $0.585/SF, premiumj of $0.0.005/SF, and spot rate of $0.575/SF, is Profti = Strike Price (Spot Rate + Premium) = $0.585/SF ($0.575/SF+0.005/SF) = $0.005/SF The break-even price for the put option is the strike price less the premium. As the spot rate falls further below the strike price, the profit would continually increase, and Hans prift could be unlimited (up to a maximum of $0.585/SF, when the price of a franc would be zero). At any exchange rate above the strike price of 58.5, Hand would not exerice the option and so would lose only the $0.005/SF premium padi for the put opiton. Like tha buyer of a call, the buyer of a put can never lose more than the premium paid up front.

Writer of Put

The position of the writer who sold the put to Hans is now explained. If the spot price of francs drops below the strike price of 58.5 cents per franc, Hans will exercise the option. Below a price of 58.5 cents per franc, the writer will lose more than the premium received from writing the option ($0.005/SF), falling below break even. Between the break even price of $0.580/SF and $0.585/SF, Hans will not exercise the option, and the option writer will pocket the entire premium of $0.005/SF. The profit/loss earned by the writer of a $0.585 strike price put, premium $0.005, at spot rate pf $ 0.575 is Profit/Loss = Premium (Strike Price Spot Rate) =$0.005/SF ($0.585/SF -$0.575/SF) = $0.005/SF But only for spot rates that are less than or equal to the strike price. At spot rate greater than the strike price, the option requires out-of-the money and the writer keeps the premium.

As we will see the premium is determined by calculating the expected payout, and a key input to establishing this value is the volatility of the price of the underlying asset.

Consider the example of a one-year European call on a share struck at $100. The holder of the option has the right but not the obligation to purchase the share for $100 after one year. . However the holder of the option is not obliged to exercise the contract. The loss is limited to the initial premium paid