Options contracts are also widely used in currency segment to hedge against any potential currency rate movement. Let us see the another example to understand the currency option contract
Suppose Crude oil is currently trading at USD 100 per barrel. Oil Refiner X wants to buy crude oil to protect itself from the huge volatility of the crude oil price.
To do the same, the company will buy 1-month crude oil option contract with the strike price of USD 103 per barrel and paid USD 2 premium for that.
Suppose after 1-month at the time of expiry the crude oil price rises to USD 110 per barrel and the company X decides to exercise the option as it is in deep the money.
After exercise, the seller will be obliged to sell crude oil at the rate of USD 103 only.
Company B’s profit will be USD 5 per barrel and the seller’s loss will be USD 5 per barrel. After buying the option, the company X will be able to limit the loss to maximum of USD 5 per barrel.
For the seller there won’t be any limit of loss. If the crude oil price touched to USD 200 per barrel, seller’s loss will be USD 95 per barrel.
Lets consider the crude oil price drops to USD 95 per barrel after 1 month and the company X decides not to exercise the option. The company X will buy the crude oil from the market itself at the lower rate.
Because of this, company X will lose maximum of USD 2 per barrel of crude oil which is the premium paid to buy the option contract.
In this case, the seller will gain just the premium paid to him.
The example shows that option contract can be used for hedging against any adverse movement of commodities prices and currency exchange rates. Here the loss is limited to the premium paid.