Introduction to Options, Hedging with Currency Options
An option is a financial contract that gives an investor the right, but not the obligation, to either buy or sell an asset at a pre-determined price (known as the strike price) by a specified date (known as the expiration date).
Options are derivative instruments, meaning that their prices are derived from the price of their underlying security, which could be almost anything: stocks, bonds, currencies, indexes, commodities, etc. Many options are created in a standardized form and traded on an options exchange like the Chicago Board Options Exchange (CBOE), although it is possible for the two parties to an options contract to agree to create options with completely customized terms.
There are two types of options: call options and put options. A buyer of a call option has the right to buy the underlying asset for a certain price. The buyer of a put option has the right to sell the underlying asset for a certain price.
Here’s a brief look at a few of the most common types of options:
Every option represents a contract between the options writer and the options buyer.
The options writer is the party that “writes,” or creates, the options contract, and then sells it. If the investor who buys the contract chooses to exercise the option, the writer is obligated to fulfill the transaction by buying or selling the underlying asset, depending on the type of option he wrote. If the buyer chooses to not exercise the option, the writer does nothing and gets to keep the premium (the price the option was originally sold for).
The options buyer has a lot of power in this relationship. He chooses whether or not they will complete the transaction. When the option expires, if the buyer doesn’t want to exercise the option, he doesn’t have to. The buyer has purchased the option to carry out a certain transaction in the future — hence the name.
Why it Matters:
Investors use options for two primary reasons: to speculate and to hedge risk. Rational investors realize there is no “sure thing,” as every investment incurs at least some risk. This risk is what the investor is compensated for when he or she purchases an asset.
Hedging is like buying insurance. It is protection against unforeseen events, but you hope you never have to use it. Should a stock take an unforeseen turn, holding an option opposite of your position will help to limit your losses.
If you’d like to read more in-depth information about options, check out these definitions:
Call Option: Option to purchase the underlying asset.
Put Option: Option to sell the underlying asset.
Options Contract: The agreement between the writer and the buyer.
Expiration Date: The last day an options contract can be exercised.
Strike Price: The pre-determined price the underlying asset can be bought/sold for.
Intrinsic Value: The current value of the option’s underlying asset.
Time Value: The additional amount that traders are willing to pay for an option.
Vanilla Option: A normal option with no special features, terms or conditions.
American Option: Option that can be exercised any time before the expiration date.
European Option: Option that can be exercised only on the expiration date.
Exotic Option: Any option with a complex structure or payoff calculation.
Hedging with Currency Options
Currency options are useful for all those who are the players or the users of the foreign currency. This is particularly useful for those who want to gain if the exchange rate improves but simultaneously want a protection it the exchange rate deteriorate. The most the holder of an option can lose is the premium he paid for it. Naturally, the option writer faces the mirror image of the holder’s picture: if you sell an option, the most you can get is the premium if the option dies for lack of exercise. The writer of a call option can face a substantial loss if the option is exercised: he is forced to deliver a currency-futures contract at a below-market price. If he wrote a put option and the put is exercised, then he is obliged to buy the currency at an above-market price.
Foreign exchange options present an asymmetrical risk profile unlike futures, forwards and currency options. This lopsidedness works in favor of the holder and to the disadvantage of the writer. This is why because the holder pays for it i.e he takes the risk. When two parties enter into a symmetrical contract ;ole a forward, both can gain or lose equally and neither party feels obliged to charge the other for the privilege. Forwards, futures, and swaps are mutual obligations; options are one-sided. The holder of a call has a downside risk limited to the premium paid up front; beyond that he gains one-for –one as the price of the underlying security.
One who has brought p put option gains one-for-one as the price of the underlying instrument falls below the strike price. Traders who have written or sold options face the upside down mirror image profit profile of those who have bought the same options.
From the asymmetrical risk profile of options, it follows that options are ideally suited to offsetting exchange risks that are themselves asymmetrical. The risk of a forward-rate agreement is symmetrical; hence, matching it worth a currency option will not be a perfect hedge. Because doing so would leave you with an open, or speculative, position. Forward contracts, futures or currency swaps are suitable hedges for symmetrical risks. Currency options are suitable in which currency risk is already lopsided, and for those who choose to speculate on the direction and volatility of rates.
Options are not only for hedgers, but also for those who wish to take a “view”. However, for one who is, say, bearish on the deutschemark, a DM put is not necessarily the best choice. One can easily bet on the direction of a currency by suing futures or forwards. A DM bear would simply sell DM futures, limiting his loss, if wants to do so, via a stop loss order.
For an investor who has a view on direction and on volatility, the option is the right choice. If you think the DM is likely to fall below the forward rate, and you believe that the market has underestimated the mark’s volatility, then buying a put on German marks is the right strategy.
Who needs American option? Because if offers an additional right- the privilege of exercise on any date up to the expiration date- it gives the buyer greater flexibility and the writer greater risk. American options will therefore tend to be priced slightly higher than European options. Even so, the American option is almost always worth more ‘alive’ than “dead”, meaning that it pays to sell rather than exercise early. The reason for this statement lies in the fact that most option trade at a price higher than the gain that would be made from exercising the option.