Financial Instrument: Options Contracts
A foreign exchange option is the derivative financial instrument that gives the right to the holder of the option but not the obligation to buy or sell the specified amount of asset at a predetermined price and on a specified date.
Options are actually a hedging technique used to protect against the foreign exchange fluctuations. Option contracts are used to protect against the losses and also serve as stop loss or loss limiting technique. In the case of the adverse state of conditions of the market or when the market trend goes against an investor’s predictions, the options contracts let the investors buy or sell the underlying assets on the predetermined rates during the contract specified period.
The cost of the option is also termed as option premium. The investor or the holder of the option contract has to pay a premium for purchasing the option contract to the seller of the option. The option seller is also known as option writer. According to the option contract, the option writer has to buy or sell the asset on the agreed price to/from the option holder on the specified date or before the specified date if the holder of the option decided to exercise the option. In simple terms, the holder of the option has the right while the option writers have obligations in relation to the performance of the option contract.
Options are traded in the stock markets as well as in the forex markets. In the option contracts, there is no physical exchange of documents between the parties to the contract. The option contract transactions are recorded on the platform through which they or traded i.e. stock exchange and the secondary market platform.
There are two types of options i.e. put option or call option and Single payment option trading (SPOT). A put option confers the right to the holder of the option to sell the underlying asset while the call option provides the right to the holder of the option to buy the particular asset. Single payment option trading contracts are automatically exercised if the predefined conditions as set by the option holder are met before the expiry of the option contract. SPOT contracts are very simple to execute and usually having a higher premium cost as compared to the conventional trading options.
The price at which the underlying asset, commodity or currency can be purchased or sold if the holder of the option contract exercises the option is known as strike price or exercise price. In other words, it is a pre-determined price which is decided at the time when the option contract is made or purchased. There are a number of strike prices above and below the current price of the underlying asset provided by the market for trading the option contracts.
Option contracts are valid for the specified time period and have a cutoff date or expiration period. After that expiry date, the holder of the option loses the right to buy or sell the underlying asset at a predetermined price. Option contract cutoff date is also referred as the expiration date of the contract.