Forex Investment and Currency Trading

One of the basic forms of forward transaction is the option contract. An example of this is an option on shares (equity option). It again involves the delivery of and payment for an underlying asset or instrument on a future date. Its unique feature lies in the fact that one of the parties to the contract can decide whether the contract will be fulfilled and thus the underlying asset delivered; he thus has the “option” of whether to exercise his right under the contract. In return for granting him this right, he pays the seller of the option an amount of money called a “premium”.

A distinction must be made between call options and put options. The buyer of a call option has the right to buy the underlying (in this example, shares of Company X) at a predetermined price. The buyer of a put option has the right to sell these shares at a predetermined price.

This form of forward transaction will be illustrated by way of an example of a call option:

The subject of the call option is shares in Company X. These are traded on the stock exchange, and the spot rate on March 1st was Euro 48. If an option contract is then executed on March 1st, one must understand the difference in roles between the two parties to the contract:

• The buyer of the option receives the right to exercise the option. In case of exercise, he purchases the predetermined number of shares in Company X for the pre-agreed price. In return for this right, he pays a premium.
• The seller of the option, often referred to as the “writer” of the option, must wait and, if the buyer decides to execute the option, is then obligated to deliver the shares of Company X at the pre-agreed price. For granting this option, he receives a premium.

The parties agree in advance on the exact price for which the writer of the option must deliver the shares of Company X in case the option is exercised. This is called the “strike price”. In the example, let us assume that the pre-agreed strike price is Euro 50.

It must also be agreed how many shares will be delivered in case the option is exercised, as well as exactly when the buyer of the option can exercise it. The number of shares to be delivered (the “size” of the contract) is generally determined by the respective futures and options exchanges; in the case of this example, an option “contract” refers to 100 shares of Company X. Let us assume that the buyer buys an option contract on March 1st which entitles him to exercise the option at any time until the third Friday of the (predetermined) expiry month; this date is called the “expiry date”. In this example, the expiry date is September 15.

Here as well, the value of the transaction depends on subsequent changes in the price of the shares of Company X. The buyer of the option has the right to buy 100 shares at a price of Euro 50 per share. He will only exercise this right if the spot price of the shares exceeds Euro 50 by September 15 at the latest. If, for example, the share prices should rise to Euro 60, then the buyer of the option would be able to buy 100 shares for Euro 5,000 (100 x Euro 50) and immediately sell them on the spot market for Euro 6,000 (100 x Euro 60). Without yet considering the cost of the premium which he paid, his profit would thus amount to Euro 1,000. If, on the other hand, the share price remains below Euro 50, the buyer of the option will not exercise the option; it would not make sense for him to purchase shares under the option at a price of Euro 50 when he can buy them more cheaply on the spot market.

For the writer of the option, the relationship is exactly the reverse. As soon as the shares rise above Euro 50, he must count on the option being exercised by the buyer and thus having to deliver the shares at a price of Euro 50. If he does not yet hold the shares, he runs the risk of suffering considerable losses when the option is exercised. For example, if the shares are trading at Euro 60 at the time the option is exercised, he must pay Euro 6,000 on the stock market to acquire the necessary shares so that he can deliver them to the buyer of the option, but for which he receives only $5,000.

Options thus lead to a “one-sided” distribution of opportunities and risks. The higher the price of the underlying share rises above Euro 50, the greater is the profit realized by the buyer of the option. On the reverse side, the writer of the option bears an (theoretically) unlimited risk of loss. In return for assuming this risk, the writer of the option demands an option premium. In this example, let us assume that the agreed premium is Euro 5. This means that the writer of the option receives a premium of Euro 500 (100 x Euro 5) at the time the option contract is executed. Depending on the subsequent price of the shares of Company X, one of the following three scenarios will arise:

• The share price of Company X remains below Euro 50: The buyer of the option does not exercise the option and loses the entire amount of the premium which he paid. The writer of the option gets to keep the premium.
• The share price enters the range between Euro 50 and Euro 55: In this case, the option will be exercised; however, the buyer of the option must deduct the $5 premium which he paid from his gross profit (difference between the spot price and the strike price) and thus he suffers a net loss. The writer of the option, conversely, realizes a net profit in the same amount.
• The share price rises above Euro 55: The buyer of the option realizes a net profit, even after deducting the cost of the premium. The higher the price of the shares rise, the higher is his net profit. The writer of the option suffers a net loss in the same amount.

There is thus an asymmetrical distribution of risk: The maximum profit with the writer of an option may realize is the amount of the premium; on the other hand, his risk of loss is – at least theoretically – unlimited. For the buyer of the option, this relationship is exactly reversed: His risk of loss is limited to the premium which he has paid. On the other hand, if the shares of Company X rise sharply in price, he realizes a considerable net profit.

Physical delivery and cash settlement; closing out of positions

In the above examples, it was assumed that the option contracts are actually fulfilled at maturity or such time as they are exercised, i.e. that the underlying asset (e.g. foreign currency or shares) is physically delivered in full, and that the price which was agreed at the time of execution is likewise paid in full. However, in practice, such transactions – with the exception of currency forwards – are frequently settled in a different way. It is in many cases usual to agree at the time the contract is executed that instead of physical delivery of the underlying asset against payment, only the net difference between the prevailing spot price and the price agreed in the forward agreement is settled as a net cash amount (cash settlement). If, in the above example, the price of shares in Company X is Euro 60 on the exercise date, the writer of the option simply pays the buyer Euro 1,000 (the difference between the spot price on the exercise date and the pre-agreed forward rate, times 100 shares).

Not to be confused with this cash settlement procedure is the “closing out”, also called “unwinding” or “liquidation”, of a forward position. In closing out a position, the party to the transaction does not wait until maturity of the forward contract or expiry of the option but rather, in advance of this date, executes a reversing transaction which is exactly the same in every respect but in the reverse direction. The original transaction is thus neutralized.