Options exist on numerous financial assets: stocks, commodities as well as foreign currency pairs.
There are some characteristics that are common to all options. An option is a contract between a buyer and a seller. The buyer has the right -but not the obligation-, to buy -or sell- the underlying asset at a specific price on or before a certain date. An option to buy is a call option; an option to sell is a put option. In exchange for this option the seller is paid a premium. The price to buy or sell specified in the contract is called the strike price. The date on which the option expires is called expiry. All options generally decline in value as the expiry approaches - this is called decay.
Let's take an example in the Forex market: You expect the exchange rate of the EUR/USD to rise. You buy a call option on the EUR/USD pair with a strike price of 1.3500 and an expiry of June 1st. Let's further assume it's now mid-March and you've got roughly ten weeks before your call option expires. At any time up until the expiration date, you can exercise your option and buy from the seller the specified number of lots of EUR/USD for 1.3500.
If the price of the EUR/USD pair remains below the 1.3500 level, the call option is said to be out-of-the-money and is nearly worthless to you. Most options do expire worthless which means the buyer gets nothing and the seller keeps the premium and goes on to sell -or write- more options.
However, if the exchange rate of the EUR/USD pair exceeds 1.3500 the call option is said to be in-the-money and is now valuable to the buyer. Let's say the exchange rate rises to 1.3650. This puts the call option in-the-money by 150 pips or $1,500 for one standard lot. At this point you, the buyer, have two choices: you can sell the option to another trader and realize a profit; or you can exercise the option and buy the specified number of lots of EUR/USD from the seller at 1.3500 yielding the $1,500 per lot gain. Either way you profit.
Not all options that are out-of-the-money remain worthless to the buyer. Let's say you bought a deep out-of-the-money call option. Let's assume the current exchange rate on our EUR/USD pair is 1.3500. You buy a call option with a strike price of 1.4000. At this point the EUR/USD has to rise 500 pips before your call option is in-the-money. However, it doesn't. It only rises 400 pips to 1.3900 and remains out-of-the-money. The value of your call option will increase because the strike price is now closer than when you bought it. This appreciation may be somewhat offset by decay as the expiry approaches. Because the value of the option has increased you can sell it to another trader before the expiry for a profit...even though it's still out-of-the-money.
Why do traders like options? Two main reasons: Option buyers lose no more than the premium they paid if the option expires worthless. Their loss is limited to the amount of premium they paid to buy the option. Traders can limit their downside risk this way. Secondly, traders use options to hedge their other positions in the forex market. Some brokers will no longer allow traders to take opposite positions in one currency. You can't be both long and short at the same time. Say you were short the EUR/USD in the forex market....that means you expected the exchange rate of the pair to drop. You could buy a EUR/USD call option to hedge your position. In the event the pair goes south, your position gains, you earn a profit and your option expires. But if it goes north the market has moved against you. Your forex position is now losing. However, your call option is gaining value. This increase in the value of your call option can offset the loss you're incurring from your short trade in the forex market. Options can be a good hedge.
