A trader who thinks that the EUR/USD price will close at or above 1.2500 at 3:00 p.m. can buy a CALL OPTION on that outcome. A trader who thinks that the EUR/USD price will close at or below 1.2500 at 3:00 p.m. can buy a PUT OPTION or sell a call option contract.
At 2:00 p.m. the EUR/USD price is 1.2490. The trader believes this will increase, so he buys 10 call options for EUR/USD at or above 1.2500 at 3:00 p.m. at a cost of $40 each.
The risk involved in this trade is known. The trader’s gross profit/loss follows the “all or nothing” principle. He can lose all the money he invested, which in this case is $40 x 10 = $400, or make a gross profit of $100 x 10 = $1,000. If the EUR/USD price will close at or above 1.2500 at 3:00 p.m. the trader’s net profit will be the payoff at expiry minus the cost of the option: $1,000 – $400 = $600.
The trader can also choose to liquidate (buy or sell in order to close) his position prior to expiration, at which point the option value is not guaranteed to be $100. The larger the gap between the spot price and the strike price, the value of the option decreases, as the option is less likely to expire in the money.
In this example, at 3:00 p.m. the spot has risen to 1.2505. The option has expired in the money and the gross payoff is $1,000. The trader’s net profit is $600.
