Hi, and Welcome to this installment of "Derivatives Demystified".
When we buy options, we pay premium amounts. A premium amount may seem like an arbitrary charge. How do I know if the premium amount is expensive or cheap?
I’ll jump straight into an example.
EURZAR is currently trading at 17.82 (down from above 18.26 after last week’s Fed announcement).
Let’s assume I’ve been waiting for ZAR to strengthen so I could take funds offshore. Specifically, I want to buy a property worth EUR280,000 in Portugal. I found the most magnificent fix-me-upper in Evora that I want to rehabilitate. It’s been on the market for quite some time. I’m not under pressure to purchase, but I want to do it soon. Don’t simply assume I’m making this investment to gain a Golden Visa.
I could buy the EUR280,000 in the spot market today and pay ZAR4,989,600*.
Or, I could buy a one-month expiry 17.82 strike EUR call. Quanta custa, this call option? (how much does it cost, this call option)? The answer: ZAR92,000. This number may seem arbitrary because we can’t see when I profit.
Let’s consider scenarios at expiry:
Possible Outcome 1: Option in-the-money
If, at the end of 1 month, EURZAR trades above 17.82, my call option will be exercised. I am protected and can buy my EUR at the same level I would’ve had I done a spot trade. But remember, I paid ZAR92,000 in premium and will pay ZAR4,989,600 for my EUR280,000, so my effective exchange rate is 18.1400**. If EURZAR is trading above my effective exchange rate, I profit.
Possible outcome 2: Option out-the-money
Or if, at the end of 1 month, EURZAR trades below 17.82, my option is not exercised. So I can buy EUR at a lower level in the market. But remember, I paid ZAR92,000. So EURZAR has to be at least below 17.4914*** for me to recoup the ZAR92,000. 17.4914 is called my breakeven level. So if EURZAR trades below my breakeven level, I profit.
*280,000 x 17.8200
**(92,000 + 4,989,000) / 280,000
***(4,989,600 – 92,000) / 280,000
To decide between buying EUR in the spot market and or buying an option, I can use the range between the breakeven and effective exchange rates. So comparing the 17.4914 – 18.1400 range to the spot of 17.8200, I conclude that I will buy the option only if I expect large enough movements in EURZAR in the next month. Movements large enough to take EURZAR out of the 17.4914 – 18.1400 range.
If it is an expected quiet month, with many public holidays and no data releases, I may be better off just trading spot or leaving a spot order. Because if it deals between 17.4914 and 18.1400 at the end of one month, the premium I paid for the option will be more than the benefit from buying them.
Not every option that glitters is (a) gold (en visa).