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Currency Options Trading - Payoff Diagrams Explained

Updated on January 19, 2012
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Philip retired from investment banking to write. To date he has written 9 books on trading forex, 3 short stories, and one poetry book.

What is a Currency Option

A currency option or as it is sometimes called an FX option, is a foreign exchange option, and is financial instrument known as a derivative. The buyer of the option has the right but not the obligation to buy (a call option) or sell (a put option) a currency in exchange for another currency at an agreed upon price (exchange rate) on a specific date in the future. For this privilege the option buyer has to pay a premium to the seller of the option. The seller of the option has the obligation to sell the option whenever it is exercised.

Long Call Pay Off Diagram

A long call is an option where the buyer is hoping that the currency will get stronger in the future. For example an investor agrees to buy a EUR/USD call option for Euro 1,000,000 at a strike price of 1.4150 for settlement on December 31st. The premium the buyer pays is 25 pips per Euro to the option seller. A pip is the least amount the rate can change for a currency pair. For the EUR/USD pair, a pip is equal to 1/100 cent and is $0.0001. Therefore as a standard lot for a EUR currency option is $100,000, a one pip change is worth $10, (100,000 x 0.0001= 10) and a premium of 25 pips per Euro is equal to $250 per lot of $100,000. (100,000 x $0.0025 = $250)

The EUR/USD call option is sometimes called a EUR call / USD put. So now you have purchased your call option and you wait while watching the market. You know that to break even on your option the exchange rate needs to reach 1.4175 because you have already paid 25 pips premium to the option seller. If when the option expires the market spot rate is below the option break even price of 1.4175 you as the option holder will allow the option to expire at a loss. Your risk as the option holder is limited to the premium of 25 pips you paid, a maximum amount of $250. Whereas, if the market spot price is above the break even price at say 1.4250, you as the option holder will exercise the option and buy Euro at 1.4175 and immediately sell the same amount in the spot market at a profit of 75 pips or $750. The seller or writer of the long call option has an unlimited risk less the premium received.

Long Put Pay Off Diagram

A long put is an option where the buyer is hoping that the currency will get weaker in the future. For example an investor agrees to buy a EUR/USD put option for Euro 1,000,000 at a strike price of 1.4225 for settlement on January 15th. The premium the buyer pays is 50 pips per Euro to the option seller. Therefore as a standard lot for a EUR currency option is $100,000, a premium of 50 pips per Euro is equal to $500 per lot of $100,000. (100,000 x $0.0050 = $500)

You know that to break even on your option the exchange rate needs to fall to 1.4175 because you have already paid 50 pips premium to the option seller. If when the option expires the market spot rate is above the option break even price of 1.4175 you as the option holder will allow the option to expire at a loss. Again your risk as the option holder is limited to the premium of 50 pips you paid, a maximum amount of $500. Whereas, if the market spot price is below the break even price at 1.4125, you as the option holder will exercise the option and sell Euro at 1.4175 and immediately buy the same amount in the spot market at a profit of 50 pips or $500. The seller or writer of the long put option like the seller of the long call option, has an unlimited risk less the premium received.


Short Call Option

A short call is where a writer or seller of an option is the counter-party to a buyer of a long call currency option. Unlike the option holder (buyer) who has the right but not the obligation to buy a currency, the option writer has the obligation to sell a currency if the option holder decides to exercise the option.

If an option writer writes a EUR/USD short call option at the strike price of 1.4175 and receives a premium of 50 pips per Euro the writer of the option is hoping that the spot price will be below 1.4175 and therefore the option expires worthless. If this becomes the case the option seller will have a profit equal to the premium received. If the option is exercised with a spot price above 1.4175 and below 1.4225 the option writer will loss part of all of the premium he received. If the spot price is anywhere above 1.4225 the option writer stands to lose $10 for every pip the price is above 1.4225.

Pay Off Diagram Short Put

A short put is the exact opposite of a short call, thus the writer or seller of an option is the counter-party to a buyer of a long put currency option. Again, unlike the option holder (buyer) who has the right but not the obligation to sell a currency, the option writer in this case has the obligation to buy a currency if the option holder decides to exercise the option.

In this example an option writer (seller) writes a EUR/USD short put option at the strike price of 1.4200 and receives a premium of 50 pips per Euro. If the spot price at expiry is at or above the strike price of 1.4200 the option will expire worthless and the writer will make a profit of the premium he received. If the option is exercised with a spot price below 1.4200 and above 1.4150 the option holder will loss part or all of the premium he received. If the spot price is anywhere below 1.4150 the option holder stands to lose $10 for every pip the price is below 1.4150.

American Style Options versus European Style Options

The major difference between American style options and European style options is the expiry date. A buyer of an American style option can exercise the option on any day from the initiation date to the expiry date. Whereas the buyer of a European style option can only exercise the option on the actual expiry date.

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    • ProTraderJohn profile image

      John Anthony 

      6 years ago from Birmingham

      This is fantastic!

    • GoldPriceNet profile image

      GoldPriceNet 

      7 years ago

      Nice Hub!

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