Another key factor in determining the premium is the volatility of the underlying instrument. High
volatility increases the price of the option, as higher volatility means there is a greater likelihood
of a larger market move that can bring about profits – potentially even before the option has reached
its strike price. A trader can choose to close his option position on any trading day, profiting from
a higher premium, whether it has risen due to increased volatility or the market moving his way.
Scenario: The current price for EURUSD pair is 1.1000. The trader speculates it will rise
within the week
Spot trade: In the first case scenario he will open a spot position for 10,000 units, on any
platform at the given spreads. If the EURUSD price moves higher, he instantly makes a profit.
Buy Call Option: In the second strategy, he buys a call option with one week to expiration at a
strike price, for example, of 1.1020. Once buying he pays the premium as shown in the trading
platform, for example, 0.0050 or 50 pips. If, at the expiration date, EURUSD exceeds the strike price,
he will earn the difference between the strike price and the prevailing EURUSD rate. His breakeven
level will be the strike price plus the premium he paid up front. He can also profit at any time prior
to expiration due to an increase in implied volatility or a move higher in the EURUSD rate. The higher
it goes, the more he can make.
Sell Put Option: In the third case, he will sell a put option. Meaning he will act as the
seller, and receive the premium directly to his account. The risk he takes by selling an option is
that he is wrong about the market – and so he must be careful in choosing the strike price. He should
be comfortable in his view that EURUSD will not be below this level at expiration.
Another way to say it is that he must be comfortable buying EURUSD at the strike price, because if
spot finishes lower, the seller has the right to “put” EURUSD to him at the strike price. In return
for taking this risk, the option seller receives the upfront premium. If spot finishes higher than the
strike price, he keeps the premium and is free to sell another put, adding to his income earned from
the first trade.
In both options trading examples, the premium is set by the market, as shown in the Forex
TemplateOptions trading platform at the time of trade. The gains and losses, based on the strike
price, will be determined by the rate of the underlying instrument at expiration.