The Price of an Option: The Option Premium
The option premium (hereafter, the premium) is also called as the price of an option. The buyer of the call or put option has the right but not obligation to buy or sell currency, respectively. Therefore, the premium is the price of having a choice.
In fact, for both types of options, call or put options, the premium is paid at the time of buying these options (actually agreed to be paid, because it’s credited or debited two working days following obtaining an options contract.) The premium is expressed in dollars per unit of currency.
Now you know why the premium is called the option price: you pay the premium upfront when you get a call or put option. You can look at the premium as a sunk cost (a cost that already incurred and cannot be recovered), especially when exercising or not exercising your right to buy or sell currency.
However, as some of the upcoming numerical exercises will show that, especially in speculation, the premium is not a sunk cost when it comes to calculating your profit or payoff.
When you look at the financial media, such as the Wall Street Journal, you’ll see that the premium is expressed in so-called pips. (In finance, a pip is 1/100th of one percent.) When you read about, for example, the premium of a call option being 3.94 per euro on the dollar-euro exchange rate, it means that you have to pay for each euro $0.0394 as a premium.
Option premiums aren’t the same for all currencies or maturities. The valuation of an option is mathematically complex. A number of variables, such as the forward rate, the current spot rate, the strike price, the time to maturity, the volatility of currencies, and the home and foreign interest rates are included in the valuation of foreign exchange options.
The table summarizes the characteristics of foreign exchange options. The buyer or the holder of a call or put option pays the premium for having a choice between exercising and not exercising the option.
While the seller or the writer of a call or put option receives and keeps the premium, he has obligations toward the buyer of the option, if the buyer decides to exercise the option.
In the case of a call option, these obligations imply that, once the buyer decides to exercise the option, the writer has to sell to the buyer of the call option a specified amount of currency at the specified strike price.
In the case of a put option, once the buyer decides to exercise the option, the writer has to buy from the buyer of the put option a specified amount of currency at the specified strike price.
|Call Option||Put Option|
|Definition||Right to buy currency||Right to sell currency|
|Who pays the premium?||The buyer (holder) of the call option, because he has the right
to buy currency
|The buyer (holder) of the put option, because he has the right
to sell currency
|Who receives the premium?||The seller (writer) of the call option||The seller (writer) of the put option|