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OUT OF THE MONEY
‘Out of the money’ is one of three terms used to describe an option’s value, or ‘moneyness’. The other two terms are ‘at the money ‘ and ‘in the money’.
When an option is out of the money, its strike price — that is, the price at which you’d exercise the option — is lower than the market price.
If you’re buying, exercising an out-of-the money option will result in a better deal than you’d find on the open market. By contrast, if you’re the seller, you’ll probably earn less or lose money.
Imagine you bought an option to exchange US Dollars for Euro. This gives you the right — but not the obligation — to exchange US Dollars for Euro at a pre-agreed exchange rate.
In our example, the option costs $20 and sets the exchange rate at EUR/USD 1.18. So you’ll get €1 for every $1.18.
If the Euro appreciates, and the EUR/USD market exchange rate goes up to 1.20, your option will be out of the money.
This is great news if you’re exchanging US Dollars for Euro. Exercising your option means €5,000 will cost $5,900, so you’ll save $80 (on the open market, €5,000 would cost $6,000 — $100 more, less the $20 premium you’ve paid for the option).
The news is less good if you’re on the other side of the arrangement, that is trading Euro for Dollars. While you’ve pocketed the $20 premium, you’re still getting $80 less than you’d have received if you’d exchanged Euro for Dollars at the market exchange rate.
- Where an out-of-the-money option has a strike price that is lower than the market price, an in-the-money option is the exact opposite. The strike price is higher than the market price, which is great if you’re selling but not if you’re buying.
- At-the-money options aren’t great for either buyers or sellers. The strike price is very similar to, if not identical to the market price. So, when you factor in the premium you pay to buy the option, exercising it means you’ll lose money.
- Out-of-the-money put options — put options are options that give you the right to sell — are cheap to buy. This is because the market needs to move a lot for the option to become profitable. By contrast, an out-of-the-money call option — call options give you the right to buy — are expensive, because the strike price is more advantageous to you than the market price.
Want to know more?
- Because out-of-the-money options can be very cheap, speculators often use them as leverage. Buying several out-of-the-money options costs less than speculating directly in foreign currency — or in other underlying assets, like stocks and shares — and can result in bigger profits (if the markets move enough for the options to become in the money). The flipside is that it’s a risky strategy.
- This article explains the potential pitfalls in the context of stock options, but the principles apply equally to foreign exchange options.
- Options make ideal risk management tools, because they give you something to fall back on if the market goes against you without creating a legal obligation to buy or sell. This academic paper explains how you can manage foreign currency risk using options in more detail.
Assure Hedge’s perspective:
“As a buyer, out-of-the-money options are an opportunity to secure a better deal than you’d get on the open market and shield yourself from exchange rate fluctuations at relatively low cost.
As a seller, out-of-the-money options can also be a winning strategy, but you need to do your research. Looking at foreign exchange forecasts can give you an idea of how likely it is for an out-of-money option to become in the money and, so, profitable for you.”
High Risk Investment Notice
Trading in leveraged financial instruments such as Options or other financial derivatives, carries a high level of risk and may not be suitable for all investors. Investors who make use of these financial products run the risk of substantial capital losses which may exceed your initial deposit. Assure Hedge (UK) Limited makes no claim or warranty regarding either the appropriateness or suitability of these instruments for your purposes whether commercial or otherwise. Assure Hedge (UK) Limited may provide general commentary or educational material available on its website or otherwise, which is not intended as investment advice. You should carefully consider your financial situation and needs and seek independent advice from a duly authorised financial adviser. Assure Hedge (UK) Limited assumes no liability for errors, inaccuracies or omissions; does not warrant the accuracy, completeness of information, text, graphics, links or other items contained within these materials. You should read and understand Assure Hedge (UK) Limited’s Terms and Conditions prior to taking any further action.
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DISCOVER OTHER CONCEPTS IN OUR CURRENCY HEDGING GLOSSARY
Leverage means investing using money you’ve borrowed, usually from a broker. When you trade on leverage, you pay your broker a sum of money called initial margin.
Mark-to-market is the accounting process that measures the real-world value of foreign exchange trades. It shows whether you’ve made a profit or a loss on a trade and whether your broker should credit your trading account or make a margin call.
A non-deliverable forward is a forward contract which is settled in your local currency. Like standard forward contracts, non-deliverable forwards are agreements to buy or sell X amount of a certain currency at a predetermined exchange rate on X date in the future.