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At the moment I have to juggle with basics of FX OPTIONS. As for every other financial instrument that we use today, those have been invented as an answer to a question/bottleneck/problem one might had in the past. Like any other product we use today, financial instruments are also solutions/standardized procedures/formulas for us to utilize.

Each time I read through a product, I always had the question "why was it created in the first place?" If I can understand the problem or difficulty one faced or the intention one had then it is much easier to logically reason pricing or theory behind these. In brief the practical usage.

So can someone please share the reasons behind options and FX options?

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migrated from quant.stackexchange.com Oct 6 '13 at 15:54

This question came from our site for finance professionals and academics.

    
Glad to see this question got migrated, welcome back to Money.StackExchange.com. It's been a while, so you might want to take a look at the About page. –  C. Ross Oct 6 '13 at 18:01
    
@C.Ross I just don't get why it's migrated to this site? Is it too simple for quant site? –  bonCodigo Oct 7 '13 at 2:48
    
Quant is more suitable of how a create an option(price, term etc), this site is more suitable for why. –  DumbCoder Oct 7 '13 at 12:25

4 Answers 4

up vote 5 down vote accepted

The main reason is that you move from the linear payoff structure to a non-linear one. This is called convexity in finance.

With options you can design a payoff structure in almost any way to want it to be. For example you can say that you only want the upside but not the downside, so you buy a call option. It is obvious that this comes at a price, the option premium.

Or equivalently you buy the underlying and for risk management reasons buy a put option on top of it as an insurance. The price of the put could be seen as the insurance premium.

You can of course combine options in more complicated ways so that you e.g. profit as long as the underlying moves strongly enough in either direction. This is called a straddle.

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"With options you can design a payoff structure in almost anyway you want it to be" I sure llike that, anyone would fall for it. 1.But what are these "anyway-s?" Can you elaborate it with an example or two? 2. why fo I want to move away from linear to non linear? –  bonCodigo Oct 6 '13 at 11:27
    
Assume a less sophisticated metal seller wants to use options. Until today he has been doing his business just fine. I believe when you said linear, it is just buy and sell it off in the traditional manner: most he would do it just a future on his gold with a gold jeweller. I want to propose him this new financial product to him. He has no idea of what derivatives are. I have to maintain his trust in my as an analyst proposing him this idea. He could say, you said Futures contract already saving me from market price risk. So why do I need more strategy? –  bonCodigo Oct 6 '13 at 11:27
    
With the futures contract you not only eliminate the risk, you also take away the chance. With options you can still have the chance even when you take away the risk. This is the non-linearity (or asymmetry if you like). –  vonjd Oct 6 '13 at 14:28
    
For the examples: Just google "option strategies" and you will find dozens of sites with all kinds of examples how to tailor payoff diagrams. –  vonjd Oct 6 '13 at 14:28
    
Futures convert one linear function into another. A flat line, to be precise, but still a line. Now why would you want a non-linear payoff? E.g. for your kids tuition. You'd really like to help them out as much as you can, but there's no need to pay more than 100% of tuition. So you write a call option at that 100% level, and pocket some initial cash now. –  MSalters Oct 7 '13 at 16:30

Do you need to buy car insurance? If you do, you are buying to open a put option.

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Exactly, options are a cheap way to reduce risk or take on extra exposure. –  luckylwk Oct 6 '13 at 9:30
    
1.How does it reduce risk to the depreciated-car owner who has the right to sell? Before options were discovered people did trade off. 2.What's the real issue options are solving here? 3.Whats the real value it is adding to the car seller and buyer? 4.What does using an option really save me from? –  bonCodigo Oct 6 '13 at 11:13
    
E.g. I have the right to sell untill 2014 Feb. If the value I get for my car will start to drop after Feb then it is worth selling. If the best values for my car is found during this period of today to Feb, then again it is worth selling. 5.But is it really true I will not get a better value after Feb? Now car is a depreciating item. 6.What if it is a house I own which usually has the appreciation factor? 7.What if it is Gold I own wwhich is highly fluctuating depends on the economy. 8.Does the valuing nature of the asset I own matter? –  bonCodigo Oct 6 '13 at 11:14
    
I am not talking about those legendary automobiles, which sells at collector's prices...after decades...Just referring to day to day deals. –  bonCodigo Oct 6 '13 at 14:37
    
Options existed before the modern automobile; they just weren't standardized by modern market theories. By buying car insurance, you reduce your risk of loss; if you total your car, they'll pay its fair value before the accident. What's more important for most people is that if you total someone else's car, the insurer will pay the fair value of their car. Yes, cars depreciate, but the concept is the same as an option; you have the option, as of the time of an accident, to basically sell the car to the insurer for fair value. You renew this option month-to-month by paying your premium. –  KeithS Oct 10 '13 at 0:47

At my soon to be legendary Stock Options Cafe, I recently wrote an article "Betting On Apple at 9 to 2." It described a trade in which a 35% move in a stock over a fixed time (2 years) would result in a 354% gain in one's bet. In this case, the options serve to create remarkable leverage for speculators.

In general, option help provide liquidity and extend the nature of the risk/reward curve.

There are option trades that range from conservative (e.g. a 'covered call') to wildly speculative, as the one I described above.

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In general economic theory, there are always two markets created based on a need for a good; a spot market (where people who need something now can go outbid other people who need the same thing), and a futures market (where people who know they will need something later can agree to buy it for a pre-approved price, even if the good in question doesn't exist yet, like a grain crop).

Options exist as a natural extension of the futures market. In a traditional future, you're obligated, by buying the contract, to execute it, for good or ill. If it turns out that you could have gotten a lower price when buying, or a higher price when selling, that's tough; you gave up the ability to say no in return for knowing, a month or three months or even a year in advance, the price you'll get to buy or sell this good that you know you need. Futures thus give both sides the ability to plan based on a known price, but that's their only risk-reduction mechanism.

Enter the option. You're the Coors Brewing Company, and you want to buy 50 tons of barley grain for delivery in December in order to brew up for the Super Bowl and other assorted sports parties. A co-op bellies up to close the deal. But, since you're Coors, you compete on price with Budweiser and Miller, and if you end up paying more than the grain's really worth, perhaps because of a mild wet fall and a bumper crop that the almanac predicts, then you're going to have a real bad time of it in January. You ask for the right to say "no" when the contract falls due, if the price you negotiate now is too high based on the spot price. The co-op now has a choice; for such a large shipment, if Coors decided to leave them holding the bag on the contract and instead bought it from them anyway on a depressed spot market, they could lose big if they were counting on getting the contract price and bought equipment or facilities on credit against it. To mitigate those losses, the co-op asks for an option price; basically, this is "insurance" on the contract, and the co-op will, in return for this fee (exactly how and when it's paid is also negotiable), agree to eat any future realized losses if Coors were to back out of the contract.

Like any insurance premium, the option price is nominally based on an outwardly simple formula: the probability of Coors "exercising" their option, times the losses the co-op would incur if that happened. Long-term, if these two figures are accurate, the co-op will break even by offering this price and Coors either taking the contract or exercising the option. However, coming up with accurate predictions of these two figures, such that the co-op (or anyone offering such a position) would indeed break even at least, is the stuff that keeps actuaries in business (and awake at night).

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