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in this video we are going to take a look at the basics of currency options a currency option is a contract between a buyer and a seller the buyer of the option gets the right to buy or sell a fixed amount of the underlying currency at a predetermined price on or before the expiration date the buyer of the option is not obligated to buy or sell the underlying currency the buyer will only do so when it's profitable let's take a look at some important elements or aspects of a currency option the first element is the price of the option also known as the premium this is the price that the buyer pays the seller the second element is the predetermined price also known as the strike price or the exercise price the third element is the spot rate or the market price of the currency and the last element is the expiration date of the contract if the buyer of the option does not exercise the option by the expiration date the buyer loses the premium and the seller keeps the premium let's take a look at basic types of currency options there are two basic types of currency options a call option that allows the buyer of the contract to buy the underlying currency at the strike price or the exercise price the buyer of the call option is expecting the spot price to rise and the seller is expecting the spot price to form the buyer will exercise the call option when the spot price is above the strike price that way the buyer is able to buy the currency at a price that is lower than the market price a put option on the other hand allows the buyer of the contract to sell the underlying currency at the strike price or the exercise price the buyer is expecting the spot price to form and the seller is expecting the spot price to rise the buyer will exercise the put option when the spot price is below the strike price that way the buyer is able to sell the currency at a price higher than the market price let's take a look at a couple of examples let's take a look at the call option first on British pounds the strike price is 160 per British pound and the call premium is two cents this option will be exercised when the spot price is above the strike price we are going to plot the spot price along the x-axis and we are going to plot the profit or loss at expiration along the y-axis at the spot price of 160 both the spot price and the strike price are the same at this point the option is known as add the money option this option will not be exercised by the buyer so the buyer loses two cents at 1:58 the buyer is not going to exercise and again loses two cents and this occurs for all prices below 158 as well so we have the following situation for the buyer this option is out of the money for the prices below 1/16 when you stand to lose money by exercising the option that option is out of the money at dollar 62 the spot price is higher than the strike price so the buyer will exercise the option the payout is going to be 162 - 160 which is the strike price so the payout is going to be 2 cents but the net profit after you take into consideration the premium is going to be 0 so 162 is the break-even price for a call option therefore the break-even price equals the strike price plus the premium at 164 the payout is going to be 4 cents but after applying 2 cents towards the premium the net profit is 2 cents so we have the dunt representing the twos and profit at 164 ad 166 the profit is going to be 4 cents at 168 the profit is going to be 6 cents so we have a line that looks like this maximum possible gain for the buyer is unlimited and the maximum possible loss for the buyer is only two cents which is the premium the option is in the money for the prices of above 1/16 the sellers position is completely opposite this is therefore a zero-sum game anytime the buyer is making money the seller is losing money and vice versa what about the spot price of 161 should the buyer exercise the option the answer is yes the spot price is greater than the strike price so the buyer should exercise the option and by doing so the buyer is cutting the loss from two cents to one cent let's take a look at an example of a put option for simplicity we are going to assume that the premium for the put option is also two cents although in reality it would be different this option will be exercised when the spot price is going to be lower than the strike price again we are going to plot the spot price along the x-axis and the profit or loss and expiration along the y-axis at 160 this option is at the money because the spot price and the strike price are the same so there is a loss of two cents the buyer will not exercise it at 162 the spot price is above the strike price so the buyer will not exercise and there is a loss of two cents for all prices above 162 therefore the buyer will not exercise and we'll lose the premium of two cents this option is out of the money for the prices of above 1/16 what about the price of 158 well now the payout is going to be 160 minus 158 that is the two cents remember this time they buyer is selling the option at 160 the market price is 158 so the profit is two two cents but the net profit after taking into account the premium is zero so 158 for the put option is the break-even price for a put option therefore the break-even price equals strike price minus the premium for the spot price of 156 the payout is four cents two senses applied towards the premium and therefore the net profit is two cents add 150 for the net profit is four cents at 152 the net profit is going to be six cents the maximum possible gain here is going to be dollar 58 because the lowest that the British Pound can drop to theoretically is zero so the maximum payout will be 160 and if you subtract the two cent premium then the maximum possible gain is going to be 158 and again the maximum possible loss is going to be two cents which is the premium this option is in the money for the spot prices of below 1/16 the sellers position is exactly opposite of the buyers position the seller loses money when the buyer is making money and vice versa what about the price the spot price of 159 should the buyer exercise the option the answer is yes because the loss will be cut from two cents to one cent a couple of important notes here an American option can be exercised on or before the expiration date a European option can only be exercised on the expiration date an option may be sold in the market instead of exercising it in summary the buyer of the option has the right but not the obligation to exercise the option a call option would be exercised when the spot price is above the strike price a put option would be exercised when the spot price is below the strike price thanks for watching this video I hope you found it useful