T2W Trading Community

A currency investor who is bullish about spot sterling vis-a-vis the US dollar buys the right to purchase GBP/USD at a given rate of exchange (the strike price). The cost of this right is the “premium”.

• • A long call is profitable (“in the money”) when the spot or futures rate of exchange is greater than the strike rate. The deeper into the money, the greater the profit from exercising the option.
• • A long call is unprofitable or “out of the money” if the spot or futures exchange rate is lower than the strike rate. If the situation remains unchanged until expiry then the option will expire unexercised and the buyer will lose the premium paid for it. The maximum loss is limited to the premium even if the spot or futures rate goes to zero.
• • Where the strike and spot/futures exchange rates are equal, the option is said to be “at the money”.

For more about long calls, click here: http://www.liffe.com/products/strategies/graphs/lcall.gif

4.2.1 Long call held to expiry – worked example

The current GBP/USD spot exchange rate is 1.5770/75. I think that GBP/USD is going to rise over the next three months. I buy one 3-month call option contract in GBP/USD spot on NYBOT with a strike rate of 1.6000, expiring in the third week of March.

Assume that the call option premium is quoted at 0.0233/0.0235 USD. The basic unit of trading for sterling on NYBOT is 125,000 GBP.

• My call option costs 125,000 X 0.0235 = 2,938 USD, which represents my margin requirement.
• At expiry, NYBOT declares a closing spot rate of 1.6350. My profit is: -
  
  (1.6350 – 1.6000) X 125,000 – 2,938 = 1,437 USD on an outlay of 2,938 = + 48.9% return on margin.
• Had the closing price at expiry been 1.5650, I would not have exercised the option and would have lost 2,938 USD (i.e. 100%)

The currency investor who is bearish about GBP/USD buys the right to sell it to someone at a strike rate. The option will be in the money when the spot or futures rate is below the strike rate and out of the money when the spot rate exceeds the strike rate

An option that expires out of the money will not be exercised. The buyer will take a loss equal to the premium paid.

For more about long puts, click here http://www.liffe.com/products/strategies/graphs/lput.gif.

4.3.1 Long put to expiry – worked example

The current spot rate for GBP/USD is 1.5770/75, but I am bearish about sterling. I buy one 3-month put option contract in GBP/USD at a strike price of 1.5500. The option is quoted at 0.0295/0.0298

• • My margin is 125,000 X 0.0298 = 3,725 USD
• • GBP/USD falls to 1.5150 at expiry. I make: -
  (1.5500 –1.5150) X 125,000 – 3,725 = 650 USD, a return of +17.45%
• • If the closing price for GBP/USD had been 1.6000, I would not have exercised the option and would have lost the 3,725 USD premium (100%).