Profit & Loss Potential

When buying an option, the profit potential is unlimited whereas the potential loss is limited to the amount paid for the premium:

When selling an option, you make the premium for the option up front, but this is the maximum profit you can make and the potential loss is unlimited -the opposite of when buying (limited gain, unlimited loss potential):

The value of an option has two elements, the intrinsic value and the time value.

Intrinsic Value

Market convention is to refer to the price of the underlying asset minus the strike of the option as the option's intrinsic value (for a Call option, for a Put it is just the opposite). Theoretically, one could argue that the forward rate of the underlying asset should be used instead of its spot, but market convention is to use the spot.

Time Value

Simply put, an option's time value is the amount by which the value of the option exceeds the intrinsic value. The volatility of the underlying asset has a significant bearing on the time value. Time value increases as volatility increases because of the Profit/Loss scenario for an option. As previously mentioned, the potential upside for an option holder is unlimited, while the downside is limited to the premium paid. Hence, an option on an asset which is more likely to take on extreme values is much more valuable than on a less volatile asset.

Interest rates differentials in the two currencies involved in a currency option trade must also be taken into consideration when pricing an option, and these are also a function of time.

This graph below shows how a call option is priced according to how close the asset price is to the strike price for the option.

For example, if you hold a Call option with a 1.2000 strike price and that the market price of EUR/USD has risen to 1.2155, your option is worth 225 pips thirty days before the option's expiration date. The intrinsic value is the difference between the strike price for the underlying asset in the option contract (1.2000) and the market price (1.2155). If you hold a call option, which gives you the right to buy EUR/USD at 1.2000 and the market price is 1.2155 the intrinsic value of the option is 155 pips. So the price of the option is the intrinsic value plus the time value (in this case 70 pips).
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