It is common for multinational corporations to put some investment in the forex. These agreements state that companies can buy or sell a given amount of foreign currency at a specified exchange rate at some future date. The good thing about having these contracts is that one is obligated to pay during maturity. With the instability of the market there is a chance that accounts will be closes and losses will be incurred. By contrast, losses on options are limited to the original premium paid.
A contract that allows the holder to purchase or sell a designated quantity of foreign currency at a specified price or exchange rate up to a specified date is a foreign exchange option. With the call option you will have the right to buy the currency by exercising the option. Remember that the last day an option can be used is before the expiration or maturity date has passed. You will call the exchange rate at which the specified foreign currency can be bought or sold as the strike price.
If you hold an American option, you are able to use it even up to its expiry date. With the European option it can only be exercised only at the expiration date. Option writers grant the right to sell and buy currency while if you buy these rights you are the option buyers. It is best to note that right to buy foreign currency or call option is also the right to sell domestic currency or put option.
An option price or premium is normally paid to the seller so the buyer can get the rights in a call option. Payment will signify that sellers must fulfill the obligations specified in the contract at the request of the buyer. The arrival of the expiration date will mean that the value of a call option is determined by the spot exchange rate and the exercise price.
When the exercise price is lesser then the spot price then the option is said to be in the money. How a holder can earn money is by exercising it at expiration and thereby purchases the sterling at a cheaper price as agreed upon in the option contract instead of in the spot market at a more expensive exchange rate. Normally the option is said to be at the money when the spot and exercise is at par.
Each time a person is buying at the exercise price and selling at a higher spot price they are trying to earn a profit. Ever time the spot price exceeds the exercise price only by an amount equal to the premium paid; a holder is able to break even.
The option buyers and sellers will earn opposite payoffs each time. It is only the premium that the seller will earn and not the gains that the buyer will have. Every time the option matures and is unused the seller profits by the full amount of the premium. The same profile will be used for other options like buying and selling a put.
In the buying a put options buyers have the right to sell a currency at a fixed price on some future date without the obligation to sell, the buyer can have the chance to make unlimited profits should the underlying currency strengthen and limit loss. What the break even point translates to is that pound sterling has appreciated sufficiently enough to compensate for the initial premium paid out. One should note that selling a put will translate that the option writer earns the premium, but accepts substantial risk should the pound sterling depreciate.