3.6.

1 Introduction
Currency Option is a financial instrument that gives its holder a right hut no obligation to
buy or sell a currency sometime in the future. Options are traded on over the counter
(OTC) as well as on orgamsed market. OTC market can be further subdivided into two
parts: retail market and wholesale market. The retail market consists of individual clients
as well as enterprises who buy Options from banks to cover against exchange risk. These
clients are generally financial institutions and portfolio managers, apart from big
enterprises. The wholesale market comprises of commercial banks and investment banks.
They operate on OTC" Option market to cover the positions for their clients or for
speculative puiposes.
The OTC Options markets represent a significant volume of transactions and they are
developing very rapidly. In terms of volume of transactions, USA, UK and Japan are on
top, followed by Switzerland, Singapore and France.
On the OTC Options market, operations are carried out either directly between
counterparties or through a broker. As indicated above, there are different categories of
operators, such as enterprises who cover their receivables and payables and future
cashflows, banks which profit by speculating, and above all, arbitrageurs who make
profit by taking advantage of price distortions on different markets.
All the operations on OTC market are carried out by telephone or by the system of Reuter
or Telerate and may take place round the clock.
3.6.2 Important Features of Currency Options
Option on OTC market is a contract between two parties. This contract gives the buyer of
the Option contract a rightand not an obligationto buy or sell a certain amount of a
currency at price fixed in advance. This right can be exercised either on on a fixed maturity date or during
the period up to maturity date. The buyer of an Option desires to avoid a
risk while the seller of an Option is ready to assume that risk.
There are two types of Options: call and put Options. A buyer (also called holder) of a
call Option acquires a right to buy currency A at a certain price against currency B.
Likewise, a buyer of put Option acquires a right to sell currency A against currency B at a
pre-fixed price.
It should be noted that a rupee call Option that gives the holder the right to buy rupees
against dollar is also a dollar put Option, giving the holder the right to sell dollar against
rupee.
When the right to use an Option is exercised on a fixed date (i.e. the date of maturity), the
Option is said to be European Option. On the other hand, when the right to use an Option
can be exercised any time during the life of the Option, up to the date of maturity, it is
referred to as American Option.
As stated earlier, it is the buyer of the Option who chooses to exercise or not to exercise
his Option. To acquire that right, he pays a premium (or price) to the seller of the Option.
As a result, the seller (writer) of the Option is under an obligation to buy or sell the
amount of currency to the holder of the Option if the latter chooses to exercise his
Option.
The positions of buyer and seller of Options are different. While the buyer of an Option
runs a risk of loss limited to the amount of premium paid and a possibility of unlimited
gain.
On the other hand, the seller of an Option has a risk of unlimited loss and the possibility
of a gain limited to the amount of premium.
On the OTC market, the size of an Option contract is of the order of 5 million dollars or,
even more, with the amounts going beyond 100 million dollars on interbank markets.
The currencies traded on the OTC market are those that are actively traded on Spot and
Forward market. These are major currencies such as US dollar, Pound sterling,

Deutschmark, Japanese yen, Swiss franc, French franc, Canadian dollar, Euro, etc.
The price of currency fixed in the contract is called exercise price. This price is chosen by
buyer on the OTC market. It is generally close to Forward price in case of European
Option.
The Option price (called premium) is paid upfront at the beginning, by the buyer to the
seller of Option. This premium puts the seller under obligation to act as per the choice of
the buyer. On the OTC market, the premium is expressed in percentage, for example, 3
per cent of the amount of the Option.
The maturity period-of an Option is limited. It may go up to 5 years. The delivery of
currency takes place after two working days of the exercise of the Option.
Options can be repurchased or resold, thus permitting the buyer to forego his right or
seller to be relieved of his obligation, as the case may be, before the date of maturity. But
the Option itself can become defunct when it is either exercised or has attained maturity.
Normally, on the OTC! market, an Option can be resold only to the bank from which it
was purchased.
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.
Covering Exchange Risk with Options
A currency option enables an enterprise to secure a desired exchange rate while retaining
the possibility of benefiting from a favourable evolution of exchange rate.
Effective exchange rate guaranteed through the use of options is a certain minimum rate
for exporters and a certain maximum rate for importers. Exchange rates can be more
profitable in case of their favourable evolution.
Apart from covering exchange rate risk, Options are also used for speculation on the
currency market.
Organised Market of Currency Options
Apart from the OTC markets for currency Options, there exist organised currency option
markets. They developed after equity Options. In 1982, stock exchanges of Montreal and
Philadelphia introduced standardised currency options. Thereafter, Chicago Mercantile
Exchange, LIFFE of London, Sydney Futures Exchange, MATIF of Paris and some
others started trading in standardised currency Options. On organised markets, two types
of Options exist: Options on cash or on spot, and Options on currency futures. The
Option on cash (or physical currency) confers the buyer the rightand not an
obligationto buy or sell the currency on spot at an agreed rate till the date of maturity.
The Option on currency futures gives the holder a right to buy or sell a future contract of
a foreign currency on a future date at an agreed rate.
The volume traded on organised markets continues to grow. Yet, it is much less than that
on the OTC Options market which offers a greater number of choices. Banks are very
active participants on the organised market. USA, France and UK are leading countries

where organised markets of Options exist.

The major participants on the organised markets are brokers, enterprises and banks that
are active on OTC markets as well.

Options are derivative instruments that give a choice to a foreign exchange market
operator to buy or sell a foreign currency on or up to a date (maturity date) at a specified
rate (strike price).

6.5. Options
6.5.1. Options definition
An option is a contract in which the option seller grants the option buyer the right to enter
into a transaction with the seller to either buy or sell an underlying asset at a specified
price on or before a specified date.
Options, like other financial instruments, may be traded either on an organized exchange
or in the over-the-counter (OTC) market.
The specified price is called the strike price or exercise price and the specified date is
called the expiration date.
The option seller grants this right in exchange for a certain amount of money called the
option premium or option price. The option seller is also known as the option writer, while
the option buyer is the option holder.
The asset that is the subject of the option is called the underlying. The underlying can be
an individual stock, a stock index, a bond, or even another derivative instrument such as a
futures contract.
The option writer can grant the option holder one of two rights. If the right is to purchase
the underlying, the option is a call option. If the right is to sell the underlying, the option
is a put option.
.Concept
Call options: Options that give the right to buy a given
amount of a financial instrument or commodity at an agreed
price within a specified time but, like all options, do not
oblige investors to do so.
Concept
Put options: Options that give the right to sell a given
amount of a financial instrument or commodity at an agreed
price within a specified time, but that do not oblige investors
to do so.
An option can also be categorized according to when it may be exercised by the buyer or
the exercise style:
European option can only be exercised at the expiration date of the contract.
American option can be exercised any time on or before the expiration date.
Bermuda option or Atlantic option is an option which can be exercised
before the expiration date but only on specified dates is called.
The terms of exchange are represented by the contract unit and are standardized for most
contracts. The option holder enters into the contract with an opening transaction.

Subsequently, the option holder then has the choice to exercise or to sell the option. The
sale of an existing option by the holder is a closing sale.
A profit profile for a call option is provided in the figure bellow. Suppose an investor is
buying a bond, which is currently selling at its exercise price of 100 Euro, and holds this
bond for three months until the option expires. Possible profits or losses will be on the
solid line. If a call option costs 4 Euro, this will be the maximum loss for a call option buyer. If
the bond price at expiration is above the exercise, the profit equals P E 4
Euro.
The maximum profit that the option writer can realize is the option price. The option buyer
has substantial upside return potential, while the option writer has substantial downside
risk.
The described call option is called a naked call option. This is a risky position because the
potential of loss is unbound.
Another less risky contract is writing a covered call. Such a contract involves the purchase
of the underlying security and the writing of a call option on that security. Profit profile
for the covered call is shown in the Figure 19. If a call option is profitable, then it it is
exercised and the covered call writer must sell the underlying security at the exercise price
(100 Euro). The maximum gain is 4 Euro, i.e. the original sale price of the call option. If
the call option is unprofitable, the covered call option writer receives 4 Euro for writing
the call, and this reduces the loss from owning the underlying security.
The purchase of a call option creates a position referred to as a long call position.
The writer of a call option is said to be in a short call position.
The buying of a put option creates a financial position referred to as a long put position.
The profit or loss for this position at the expiration date depends on the market price of the
underlying asset. As with all long option positions, the loss is limited to the option price.
The profit potential, however, is substantial: The theoretical maximum profit is generated
if assets price falls to zero.
Writing a put option creates a position referred to as a short put position. The profit and
loss profile for a short put option is the opposite of the long put option. The maximum
profit from this position is the option price.

6.5.2. Components of the Option Price

The theoretical price of an option is made up of two components:
intrinsic value;
premium over intrinsic value.
The intrinsic value is the options economic value if it is exercised immediately. If no
positive economic value would result from exercising immediately, the intrinsic value is
zero.
For a call option, the intrinsic value is the difference between the current market price of
the underlying and the strike price. If that difference is positive, then the intrinsic value
equals that difference; if the difference is zero or negative, then the intrinsic value is equal
to zero.
Concept Intrinsic value of an option: The profit available from
immediately exercising an option. Where the value of the

right granted by the option is equal to the market value of the

underlying instrument (the intrinsic value is zero), the option
is said to be at-the-money. If the intrinsic value is positive,
the option is in-the-money. If exercising an option would
produce a loss, it is out-of-the-money.
For a put option, the intrinsic value is equal to the amount by which the underlyings
market price is below the strike price.
Time premium of an option, or time value of the option, is the amount by which the
options market price exceeds its intrinsic value. It is the expectation of the option buyer
that at some time before the expiration date the changes in the market price of the
underlying asset will increase the value of the rights of the option. Because of this
expectation, the option buyer is willing to pay a premium above the intrinsic value.
An option buyer has two ways to realize the value of an option position.
The first way is by exercising the option. The second way is to sell the option in the
market.
Put-Call Parity Relationship. For a European put and a European call option with the
same underlying, strike price, and expiration date, there is a relationship between the price
of a call option, the price of a put option, the price of the underlying, and the strike price.
This relationship is known as the put-call parity relationship.
The relationship is equal to:
Put option price Call option price = Present value of strike price + Present
value of cash
distribution Price of underlying asset
Put-call parity implies that:
Call option price >= Put option price - Lending present value of exercise price
The value Put option price - Lending present value of exercise price has been called
Mertons lower bound. It follows that the cash flows from buying a call option can never
be less than buying the underlying security and borrowing the underlying value of the exercise
price. Mertons bound is illustrated in the Figure 21.
PAGE 136/140 & Fin PDF

As the price of the

underlying asset rises, the value of the call approaches Mertons bound, and consequently,
the value of a put gets very small. When the price of the underlying asset is small, the
value of the call option is small, and the value of a put becomes large.

6.5.3. Determinants of the Option Price

The factors that affect the price of an option include:
Market price of the underlying asset.
Strike (exercise) price of the option.
Time to expiration of the option.
Expected volatility of the underlying asset over the life of the option.
Short-term, risk-free interest rate over the life of the option.

 Anticipated cash payments on the underlying over the life of the option.
The impact of each of these factors may depend on whether (1) the option is a call or a put,
and (2) the option is an American option or a European option.
Market price of the underlying asset. The option price will change as the price of the
underlying asset changes. For a call option, as the underlying assetss price increases (all
other factors being constant), the option price increases. The opposite holds for a put
option, i.e. as the price of the underlying increases, the price of a put option decreases.
Exercise (strike) price
The exercise price is fixed for the life of the option. All other factors being equal, the
lower the exercise price, the higher the price for a call option. For put options, the higher
the exercise price, the higher the option price.
Time to expiration of the option. After the expiration date, an option has no value. All
other factors being equal, the longer the time to expiration of the option, the higher the
option price. This is because, as the time to expiration decreases, less time remains for the
underlying assets price to rise (for a call buyer) or fall (for a put buyer), and therefore the
probability of a favorable price movement decreases. Consequently, as the time remaining
until expiration decreases, the option price approaches its intrinsic value.

Expected Volatility of the Underlying asset over the life of the option. All other factors
being equal, the greater the expected volatility (as measured by the standard deviation or
variance) of the underlying, the more the option buyer would be willing to pay for the
option, and the more an option writer would demand for it. This occurs because the greater
the expected volatility, the greater the probability that the movement of the underlying will
change so as to benefit the option buyer at some time before expiration.
Short-term, risk-free interest rate over the life of the option. Buying the underlying
asset requires an investment of funds. Buying an option on the same quantity of the
underlying makes the difference between the underlyings price and the option price
available for investment at an interest rate at least as high as the risk-free rate.
Consequently, all other factors being constant, the higher the short-term, risk-free interest
rate, the greater the cost of buying the underlying asset and carrying it to the expiration
date of the call option. Hence, the higher the short-term, risk-free interest rate, the more
attractive the call option will be relative to the direct purchase of the underlying. As a
result, the higher the short-term, risk-free interest rate, the greater the price of a call option.
Anticipated cash payments on the underlying over the life of the option cash payments
on the underlying tend to decrease the price of a call option. The cash payments make it
more attractive to hold the underlying than to hold the option. For put options, cash
payments on the underlying tend to increase the price.
6.5.4. Option pricing models
An option pricing model uses a set of assumptions and arbitrage arguments to derive a
theoretical price for an option. Deriving a theoretical option price is much more
complicated than deriving a theoretical futures or forward price because the option price
depends on the expected volatility of the underlying over the life of the option.
Several models have been developed to determine the theoretical price of an option. The

most popular one was developed by Fischer Black and Myron Scholes (1973) for valuing
European call options on common stock.
6.5.5. Mixed strategies in options trading
Call and put options and the buying and writing of options can be combined to try to profit
from expected conditions in the market. Some of such strategies are as follows:
Cases where a trader either buys or writes options but does not do both
Straddle a call and a put at the same strike price and expiry date
Strangle a call and a put for the same expiry date but at different strike prices
Strap two calls and one put with the same expiry dates; the strike prices might be the
same or different
Strip two puts and one call with the same expiry date; again strike prices might be the
same or different
In general, the buyer of these options is hoping for market prices to move sharply but is
uncertain whether they will rise or fall. The buyer of a strap gains more from a price rise
than from a price fall; the buyer of a strip gains more from a price fall. The writer in all
four cases is hoping that the market will remain stable, with little change in price during
the life of the option.
Spreads: combinations of buying and writing options
Butterfly buying two call options, one with a low exercise price, the other with a high
exercise price, and writing two call options with the same intermediate strike price or the
reverse.
Condor similar to a butterfly, except that the call options which are written have
different intermediate prices.
Both a butterfly and a condor are vertical spreads all options bought or sold have the
same expiry date but different strike prices. Horizontal spreads have the same strike prices
but different expiry dates. With diagonal spreads both the strike prices and the expiry dates
are different. Other mixed strategies have equally improbable names. They include vertical
bull call; vertical bull spread; vertical bear spread; rotated vertical bull spread; rotated
vertical bear spread.

Stock Options: this is a contract in which one side pays money today for the option to purchase
(a call) or sell (a put) a share of stock at a fixed price in the future.
Currency Options
Currency options are both exchange-listed and over-the-counter (OTC). Call options are
contracts
giving the owner ("buyer") the right, but not the obligation, to purchase a quantity of foreign
currency at a fixed price (strike price) for a limited interval of time. Put options give the buyer
the
right to sell. The seller of the option is called the writer. The buyer pays an amount called a
"premium" to the seller for the put or call option. The Philadelphia Stock Exchange lists calls and
puts on foreign currency. Calls and puts on currency futures contracts are listed on the IMM and
SIMEX.

The Definition or the Basic Terms:

A foreign-exchange option is a contract for future delivery of a specific currency
in exchange for another, in which the holder of the option has the right to buy or
sell the currency at an agreed price. The right to buy is a call ; the right to sell ,
a put. For such a right the buyer pays a price called the option premium. The
option seller receives the premium and is obliged to made delivery at the
agreed-upon price if the buyer exercises his option. In some options, the
instrument being delivered is the currency itself, in others, it is a futures
contract on the currency.
American options permit the bolder to exercise at any time before the expiration date, European
options only on the expiration date.
Structure of the Market
Options are purchased and traded either on an organized exchange (such as the Philadelphia Stock
Exchange on in the over-the counter (OTC) market. Exchange-traded options or listed options are
standardized contracts with predetermined exercise prices, standard maturities (one, three, six, nine,
and twelve months), and fixed maturities (March, June, September and December). Options are
traded in standard contracts half the size of the IMM futures contracts, Cross-rate options are also
available for the DM/Y,
/DM, and /Y. By taking the U.S. dollar out of the equation, cross-rate option allow one to hedge
directly the currency risk that arises when dealing with non dollar currencies. The PHLX trades both
American style and European style currency options. It also trades month end options which ensures
the availability of a short-term currency options at all times and long term options which extend the
available expiration months on PHLX dollar based and cross rate contracts providing for 18, 24, 30
and 36 months European style options. On a later date the PHLX introduced a new option contract
called Virtual Currency Option, which is settled in us dollars rather than in the underlying currency.
Other organized options exchanges are located in Amesterdam (European Options Exchange),
Chicago (Chicago Mercantile Exchange) and Montreal (Montreal Stock Exchange) OTC options are
contracts whose specifications are generally negotiated as to the amount, exercise price and rights,
underlying instrument, and expiration. OTC currency options are traded by commercial and
investment banks in virtually all finance centers. OTC activities is concentrated in London and New
York and it centers on the major currencies, most often involving U.S. dollars against pounds
sterling, Deutsche marks, Swiss francs, Japanese yen, and Canadian dollars Branches of foreign
banks in the major financial centers are generally willing at write options against the currency of
their home country.
The structure of the OTC options market consists of two sectors1. Retail Market:
This market is composed of nonblank customers who purchase from banks what amounts to
customized insurance against adverse exchange rate movements and,
2. Whole Sale Market
A whole sale market is composed of commercial banks, and specialized trading firms. This is mainly
involve in inter bank OTC trading, trading on the organized exchanges.
Most retain customers for OTC options are either corporations active in international trade of
financial institutions with multicurrency asset portfolios.

These customers could purchase foreign exchange puts of calls on organized exchanges, but they
generally turn to the banks for options in order to find precisely the terms that match their needs.
Contracts are generally tailored with regard to amount, strike price, expiration date and currency.
Currency call Options:
After understanding the structure of the currency option market- both the retail and the whole sale
markets, it would be useful to understand the currency call options. In the following paragraphs we
would be involved in understanding the currency options available to a buyer.
A currency call option is a contract that gives the buyer the right to buy a foreign currency at a
specified price during the prescribed period. Firms buy call options because they anticipate that the
spot rate of the underlying currency will appreciate. Currency option trading can take place for
hedging or speculation.
Hedging in the call Option Market:
Multinational companies with open positions in foreign currencies can utilize currency call options.
For example, suppose that an American firm orders industrial equipment form a German company,
and its payment is to be made in German marks upon delivery. A German mark call option call option
lacks in the rate at which the U.S company can purchase marks for dollars. Such an exchange
between the two currencies at the specified strike price can take place before the settlement date.
Thus the call option specifies the maximum price which the U.S.
company must pay to obtain marks. If the spot rate falls below the strike price by the delivery date,
the importer can buy marks at the prevailing spot rate to pay for its imports and can simply let its call
option expires.
Speculating in the call Option Market:
Firms and individuals may speculate with currency call options based on their expectations of
exchange-rate fluctuations for a particular currency. The purpose of speculation in the call option
market is to make a profit from exchange-rate movements by deliberately taking an uncovered
position. If a speculator expects that the future spot rate of a currency will increase, he makes the
following transactions:
The speculator will:
1. Buy call options of the currency
2. Wait for a few months until the spot rate of the currency appreciates high enough
3. Exercise his option by buying the currency at the strike price, and
4. Sell the currency at the prevailing spot rate.
Currency Put Options: A currency put option is simply a contract that gives the holder the right to
sell a foreign currency at a specified price during a prescribed period. People buy currency put
options because they anticipate that the spot rate of the underlying currency will depreciate.
Multinational companies who have open positions in foreign currencies can employ currency put
options to cover such positions. For example, assume that an Indian company which has sold an
airplane to a Japanese firm and has agreed to receive its payment in Japanese yen. The exporter may
be concerned about the possibility that the yen will depreciate when it is scheduled to receive its
payment from the importer. To protect itself against such a yen depreciation, the exporter could buy
yen put options, which would enable it to sell yen at the specified strike price. In fact, the exporter
would lock in the minimum exchange rate at which it could sell Japanese yen in exchange for U.S.
dollars over a specified period of time. On the other hand, if the yen appreciates over this time
period, the exporter could let the put options expire and sell the yen at the prevailing spot rate.
Individuals may speculate with currency put options based on their expectations of exchange rate
fluctuations for a particular currency. For example, if speculators believe that the German mark will
depreciate in the future, they can buy mark put options, which will entitle them to sell marks at the

specified strike price. If the marks spot rate depreciates as expected, they can buy marks at the spot
rate and exercise their put options by selling these marks at the strike price. Speculators do not need
to exercise their put options in order to make a profit. They could make a profit from selling put
options because put option premiums fall and rise as exchange rates of the underlying currency rise
and fall. The seller of put options has the obligation to purchase the specified currency at the strike
price from the owner who exercises the put option. If speculators anticipate that the currency will
appreciate, they might sell their put options. But if the currency indeed appreciates over the entire
period, the put option will mot e exercised. On the other hand, if they expect that the currency will
depreciate, they will keep their put options. Then they will sell their put options when the put option
premiums go up.
Hedging Currency Positions (Various Options)
Hedging currency has various options such as with foreign currency options, hedging with currency
futures and contracts etc.
Let us now explain each one by one:
Hedging Currency Positions with Foreign Currency Options:
In 1972, the flexible exchange rate system was re established and since then the multinational
corporations, international banks and governments have had to deal with the problem of exchange
rate risk. Until the introduction of currency options, exchange rate risk usually was hedged with
foreign currency forward or futures contracts. Hedging with these instruments allows foreign
exchange participants to lock in the local currency values of their revenues of expenses. However,
with exchange-traded currency options and dealers options, hedgers, for the cost of the options, can
obtain not only protection against adverse exchange rue movements, but benefits if the exchange
rates move in favorable directions.
Hedging with Currency Futures and Contracts:
With the following options the foreign currency can be hedged.
1. By going long in a currency call option, the investor can lock in the maximum dollar costs of a
future cash outflow or liability denominated in a foreign currency while still maintaining the chance
for lower dollar outlays if the exchange rate decreases. In contrast, by going long in a currency put,
the investor can lock in the minimum dollar value of a future inflow or asset denominated in foreign
currency while still maintaining the possibility of a greater dollar inflows in case the exchange rate
increases. With foreign currency futures and forward contracts, the domestic currency value of future
cash flows or the future dollar value of assets and liabilities denominated in another currency can he
locked in. Unlike Option hedging,
Options
While the forward or futures contract protects the purchaser of the contract fro m the adverse
exchange rate movements, it eliminates the possibility of gaining a windfall profit from favorable
exchange rate movement.
An option is a contract or financial instrument that gives holder the right, but not the obligation, to
sell or buy a given quantity of an asset as a specified price at a specified future date. An option to buy
the underlying asset is known as a call option and an option to sell the underlying asset is known as a
put option. Buying or selling the underlying asset via the option is known as exercising the option.
The stated price paid (or received) is known as the exercise or striking price. The buyer of an option
is known as the long and the seller of an option is known as the writer of the option, or the short. The
price for the option is known as premium.
Types of options: With reference to their exercise characteristics, there are two types of options,
American and European. A European option cab is exercised only at the maturity or expiration date
of the contract, whereas an American option can be exercised at any time during the contract.

Swap operation
Commercial banks who conduct forward exchange business may resort to a swap operation to adjust
their fund position. The term swap means simultaneous sale of spot currency for the forward
purchase of the same currency or the purchase of spot for the forward sale of the same currency. The
spot is swapped against forward. Operations consisting of a simultaneous sale or purchase of spot
currency accompanies by a purchase or sale, respectively of the same currency for forward delivery
are technically known as swaps or double deals as the spot currency is swapped against forward.
Options:
Exchange-traded options are standardised contracts whereby one party has a right to
purchase something at a pre-agreed strike price at some point in the future. The right,
however, is not an obligation as the buyer can allow the contract to expire and walk away.
The cost of buying an option is the sellers premium which the buyer must pay to obtain the
option right. There are two types of option contracts that can be either bought or sold:
Call A buyer of a call option has the right but not the obligation to buy the asset at the
strike price (price paid) at a future date. A seller has the obligation to sell the asset at the
strike price if the buyer exercises the option.
Put A buyer of a put option has the right, but not the obligation, to sell the asset at the
strike price at a future date. A seller has the obligation to repurchase the asset at the strike
price if the buyer exercises the option.