Different
strategies of options may be adopted depending on the anticipations of the
market as regards the evolution of exchange rates and volatility.
ANTICIPATION OF APPRECIATIONS OF UNDERLYING CURRENCY
Buying of a call
Option may result into a net gain if market rate is more than the strike price
plus the premium paid. Equation gives the profit of the buyer of the call
Option. Call option will be exercised only if the exercise price is lower than
spot price.
Profit = St - X - c
for St > X }
= - c for St
< X }
Where
St = spot rate
X = strike price
c = premium paid
The profit profile will be exactly
opposite for the seller (writer) of a call Option. Graphically, Figure presents
the profits of a call Option. Examples call Option strategy.
Example: Strategy with
call Option.
X = $ 0.68/DM
c = 2.00
cents/DM
On expiry date of Option (assuming
European type), the gain or loss will depend on the then Spot rates (St)
as shown in the Table:
TABLE Spot Rate and Financial Impact of
Call Option
St
|
Gain (+)/Loss (-)for
The buyer of call option
|
$ 0.6000
|
- $ 0.02
|
$ 0.6200
|
-$0.02
|
$ 0.6400
|
- $ 0.02
|
$ 0.6500
|
- $ 0.02
|
$ 0.6600
|
- $ 0.02
|
$ 0.6700
|
-$0.02
|
$ 0.6800
|
-$0.02
|
$ 0.6900
|
-$0.01
|
$ 0.7000
|
$0.00
|
$0.7100
|
+ $0.01
|
$0.7200
|
+ $ 0.02
|
$ 0.7400
|
+ $ 0.04
|
$ 0.7600
|
+ $ 0.06
|
o
For St < $ 0.68/DM, the Option is
allowed to lapse. Since DM can be bought at a lower price than X, the loss is
limited to the premium paid, i.e. $ 0.02.
o
At St > 0.68, the Option will be
exercised.
o
Between 0.68 < St < 0.70, a part
of loss is recouped.
o
At St > 0.70, net profit is
realized.
Reverse profit
profile is obtained for the writer of call Option.
ANTICIPATION OF DEPRECIATION OF UNDERLYING CURRENCY
Buying of a put Option anticipates a decline in the underlying
currency. The profit profile of a
buyer of put Option is given by the equation. A put Option will be exercised
only if the exercise price is higher than spot rate.
Profit = X - St
- p for X > St }
= - p for X < St
}
Here p
represents-the premium paid for put Options.
The opposite is the profit profile for the seller of a put Option.
Graphically Figure presents the profits of a put Option. Example illustrates a
put Option strategy.
Example: Strategy
with put Option.
Spot rate at the
time of buying put Option: $ 1.7000/E
X= $ 1.7150/E
p = $ 0.06/E
The gain/loss
for the buyer of put Option on expiry are given in Table
o
For St > 1.7150, the Option will not be exercised
since Pound sterling has higher price in the market. There will be net loss of
$ 0.06.
o
For 1.6550 < St < 1.7150, Option will be
exercised, but there will be net loss.
o
For St < 1.6550, the Option will be exercised and
there will be net gain.
TABLE Spot Rate and Financial Impact of Put Option
St
|
Gain(+)/loss (-)
|
1.6050
|
+0.050
|
1.6150
|
+0.040
|
1.6250
|
+0.030
|
1.6350
|
+0.020
|
1.6450
|
+0.010
|
1.6500
|
+0.005
|
1.6550
|
+0.000
|
1.6600
|
-0.005
|
1.6650
|
-0.010
|
1.6750
|
-0.020
|
1.6850
|
-0.030
|
1.6950
|
-0.040
|
1.7050
|
-0.050
|
1.7150
|
-0.060
|
1.7250
|
-0.060
|
1.7350
|
-0.060
|
The reverse will
be the profit profile of the seller of put Option.
STRADDLE
A straddle strategy involves a combination of a call and a put
Option. Buying a straddle means buying a call and a put Option simultaneously
for the same strike price and same maturity. The premium paid is the sum of the
premia paid for each of them. The profit profile for the buyer of a straddle is
given by equation:
Profit = X - St
- (c + p) for X > St (a)
Profit = St,
- X - (c + p) for St
> X (b)
It is to be noted that the equation
a is the combination of use of put Option (X - St - p) and non-use
of call Option (- c) whereas the equation b is the combination of use of call
Option (St - X - c) and non-use of put Option (- p). In other
words, while equation a shows the use of put Option, equation b relates to the
use of call Option. Figures show graphically .the profit files of a straddle.
The straddle strategy is adopted when a buyer is
anticipating significant fluctuations of a currency, but does not know the
direction of fluctuations. On the contrary, the seller of straddle does not
expect the currency to vary too much and hopes to be able to keep his premium.
He anticipates a diminishing volatility. He makes profits only if the currency rate is
between X1 (X - c - p) and X2 (X + c + p). His profit is
maximum if the spot rate is equal to the exercise price. In that case, he gains
the entire premium amount. The gains for the buyer of a straddle are unlimited
while losses are limited.
SPREAD
Spread refers to
the simultaneous buying of an Option and selling of another in respect of the
same underlying currency. Spreads are often used by traders in banks.
A spread is said
to be vertical spread or price spread if it is composed of buying and
selling of an Option of the same type with the same maturity with different
strike prices. Spreads are called vertical simply because in newspapers,
quotations of Options for different strike prices are indicated one above the
other. They combine the anticipations on the rates and the volatility. On the
other hand, horizontal spread combines simultaneous buying and selling
of Options of different maturities with the same strike price.
When a call option is bought with a lower strike price and another
call is sold with a higher strike price, the maximum loss in this combination
is equal to the difference between the premium earned on selling one option and
the premium paid on buying another. This combination is known as bullish call
spread. The opposite of this is a bearish call.
The other combination is to sell a put Option with a higher strike
price of X2 and to buy another put Option with a lower strike price
of X1 Maximum gain is the difference between the premium obtained
for selling and the premium paid for buying. This combination is called bullish
put spread while the opposite is bearish put. Figures show the profit profile
of bullish spreads using call and put Options respectively. The strategies of
spread are used for limited gain and limited loss.
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