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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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24.5 FX Options from the Buy-Side Perspective

24.5.1 Strike versus Leverage

In FX, we are always bullish and bearish simultaneously. If we buy EUR/USD then we sell USD/EUR. An option helps express a view in a risk-managed way, and of course there is a price to pay: the premium. A very confident player will not buy an option as their belief is so strong that they do not see any use in it. That confident investor would prefer a forward or spot contract. The more risk averse the player, the more protection is necessary to make them play; hence, the market for insurance. But there is another element that makes options very attractive instruments for speculation: the leverage. Let us suppose you can spend 2% of your wealth to invest or to gamble in the FX market. With this 2%, you can either buy another currency or buy an option, either put or call, or an exotic instrument that can be even cheaper. Let us also assume that the investment horizon is 1 year and that the option you are considering is the EUR/USD put. In Table 24.8, I present different strategies that involve buying a currency forward, buying a EUR/USD put at the money forward, and buying an out-the-money put.

Table 24.8 Investor Choices

NumberTable

Now let us analyze these three strategies more closely. In all three strategies, we allocate 2% of our capital to bet on EUR/USD.

In the first strategy, we do not use leverage at all, we ...

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