Option Trading confers the right on the holder/buyer to buy/sell a specified asset (here foreign currency) on a specific price on or before a specific date but he has no obligation to buy/sell. Seller/Writer has an obligation to fulfill the contract if buyer/holder exercises the option. Whenever a person has an intention to buy foreign currency by paying a premium amount immediately, and settling the same on a later date, it is known as a Call option. Call option has two parties, one a buyer of a Call option and other a seller of a Call option.
Example:
Mr. A is interested in buying a US dollar. Spot rate is US$ 1 = 45.50. Mr. A believes that some 30 days down the line, with the budget coming up and the price of the US dollar would increase. Not wanting to take any chances, he goes to a dealer and purchases a call option for US dollars 1,000 after 1 month. The dealer, knowing the Forex market only too well, agrees to that but demands Rs. 100 as a risk measure that he is ready to take. So now they enter into a contract whereby Mr. A would pay the dealer Rs. 100 right now and after one month, the dealer would have to take delivery of the US dollar for the agreed amount of US$ 1 = Rs. 45.50.
After 30 days, the budget is out and has an impact on the price of the US dollar in two instances:
- Price of the US dollar decreases to US$ 1 = Rs.44.50: Mr. A will purchase the US dollar from the open market. He will not go to the dealer. In such a case, he would lose the premium amount or the advance amount of Rs. 100 paid by him while entering into this contract.
- Price of the US dollar increased to US$ 1 =Rs.46.50: In this case, the buyer ideally would prefer to go to the dealer and sell the US Dollar as he has to pay Rs.45.50 per
US$. In such a case, the buyer is in profit of Rs. 1 per dollar. For US Dollar 1,000 the profit will be Rs. 1,000. If the premium of Rs. 100 paid by Mr. A is deducted, the net profit to Mr. A is Rs.900 (1,000-100). In this case the option seller would have to bear a net loss of Rs.900.
In the above example we saw that the option buyer (i.e. seller of the US Dollar), Mr. A has a right to approach the dealer to take the delivery of the US Dollar if the price of the US Dollar increases, but if the price of US Dollar decreases, he has a choice of stepping back. The option seller (i.e. buyer of the US Dollar) on the other hand does not have any right to step back if the option buyer (i.e. seller of the US Dollar) comes and forces him to take the delivery of the US Dollar.
Such a transaction where Mr. A, who pays the premium amount, has an intention to buy foreign currency is known as a Call Option.
In the above example, Mr. A is a buyer of a Call option. He has a right and the dealer over here is a seller of the Call option, who has an obligation. The buyer of a Call option would pay the premium amount while entering into the contract and the seller of the Call Option would always receive the premium amount while entering into the contract. It also conveys that the loss of a buyer is limited whereas the loss of the seller is unlimited.
In case of a Call option, if the spot rate on maturity is more than the contract rate, there will be a profit to the option buyer and a loss to the option seller. If the spot rate on maturity is less than the contract rate, there will be a loss to the extent of the premium paid to the option buyer and profit to the option setter to the extent of premium received. Call options are exercised by buyers of foreign currency; for example, by Importers.