What is a Call Option?
If you want to trade the rising price of a currency pair you can either buy it directly in the market or buy a Call option contract. The direct trade places you into the market immediately however an option gives you the choice or the 'option' to enter at a later date (up until a certain date).
A Call option's book definition is a contract that gives you the right to buy a currency pair at a certain price over a certain period of time. If the currency pair rises relative to the price you hold, you may 'exercise' your option and benefit through buying at the cheaper price. The following example uses the currency pair euro to US dollar (EUR/USD) to explain this trade.
EUR/USD Call Option Trade
Say EUR/USD is trading at 1.10 and you are expecting positive economic news from Europe which will strengthen the euro and push EUR/USD higher. However, you don't have the confidence to buy the pair directly because there is a possibility you face a large risk if the price is volatile and/or plummets. Instead you may buy a Call option, giving you the right to buy EUR/USD at a certain price for a period of time. Buying a Call is a limited risk trade.
You choose to buy a Call option giving you the right to buy 10,000 EUR's at 1.11 (100 pips higher than current market price) over the next month. This option costs you $50.
Call option details:
Strike is 1.11
Expiry date 1 month from today
Premium to pay is $50
Now, imagine the scenario in which EUR/USD does what you expect, it moves up and before the end of the month it has moved to 1.15. You decide to 'exercise' your option, that is via your option you buy EUR/USD at 1.11. At the same time you can sell in the market at 1.15. You are buying at 1.11 and selling at 1.15, thus profiting from the difference of $0.04 for every euro traded. In this example, that is 10,000 Euros x 0.04 = $400. The graph below shows how this would look.
If you then subtract the premium you paid for the option ($50), you will have $350 net profit.
Looking at the alternative scenario, if your bet goes against you and EUR/USD price falls, an option does not behave like a direct trade in the market. When buying a currency pair directly you may be exposed to large losses should the market fall and you would control maximum risk by placing a stop-loss at a lower level. When buying an option, maximum risk is the premium paid at open, in this case that is $50. Even if EUR/USD price headed to zero you are not stuck in an increasingly losing trade. The graph below shows how losses are incurred when buying EUR/USD directly at 1.10.
On ORE's web-trading platform, options are cash-settled. This means the actual physical transaction of the currency pair is not required and you do not have to 'exercise' the option to receive your profit. Instead, the running profit or loss of an option trade is calculated for you and when you close the trade, or it expires, cash is credited to your free balance (if the option has premium value). Trades can be closed any time before expiry (during trading hours) to lock-in profit or reduce a loss.