Why Options? Differences and Tradeoffs
The cost of options are always more expensive than forwards – the insurance benefit of the option has to be paid for. The tradeoffs and differences between an option and a forward are:
• Options have limited loss potential while the loss on a forward contract is theoretically unlimited.
• Options offer more leverage or “bang for the buck”: A forward position may require 5% collateral, with the possibility of further margin calls, while an option can be bought for a fraction of that amount and a long option position carries no margin requirements.
• Options can be combined in ways that offer both limited risk and reward, reducing the cost further.
• Where options are perceived as being “too expensive”, they might be sold for a profit. Note that selling “naked” options carries theoretically unlimited risk.
• An option is only a potential claim on the underlying – it has to be exercised to become an FX contract.
• Long options can be sold out for immediate payment – forwards are only settled on the end date of the contract.
• In different countries, options may have different tax and financial accounting treatment. This may create advantages and drawbacks.
• Forwards require no up-front cashflow (save for margin, where required) – buying options requires an up-front investment in the premium.
• Options are “wasting” assets: with each day that passes the time-value portion of the option decreases.
• Options can be combined to allow the construction of a bias-free position, i.e., the trader is not necessarily betting on the direction of the market, but can bet on the volatility.
While it is important to bear in mind that an option is always more expensive than an equivalent forward contract (due to the time value payment), it is equally important to remember that any hedging problem which can be solved with forwards, can also be solved with options (provided that there is a liquid market). Conversely, using only forwards can replicate few of the hedges accomplished with options.
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