STRIKE PRICE AND STRIKE SELECTION

The preset price is called the strike price or the exercise price, which is the predetermined rate of exchange at which exercise takes place. The strike is usually chosen at a level close to the current foreign exchange spot of forward rate but may be at any reasonable level. The premium (price) of an option is very sensitive to the relationship of the strike to the current spot foreign exchange rate. However, in general, both buyers and sellers of options will select a strike based on several factors, including their forecast or expectations of the value of the underlying currency during the lifetime of the option and the option’s payoff (profit/loss) profile.
The strike price is the exchange rate at which the option may be exercised.
For example, a market participant with a bullish view for the dollar against the Swiss franc may choose to purchase the dollar in the forward foreign exchange market because there is a belief that the value of the dollar will appreciate against the Swiss franc. A long position in the underlying (dollar) represents the most bullish view of the underlying. However, a long dollar forward foreign exchange position has a payoff profile of unlimited gains if the dollar increases in value and unlimited losses if the dollar decreases in value. If the market participant wishes to eliminate the potential loss while keeping the potential gains, this participant may purchase a dollar call/Swiss franc put instead of purchasing the dollars in the forward foreign exchange market. Thus, a long dollar call represents a bullish view of the dollar but with protection. The cost of the protection is the upfront premium, thus there is a trade-off between the premium payment and the payoff profile.
The market participant now needs to select a strike rate. Should it be in-, at- or out-of-themoney?. In order to make this decision, the market participant will need to consider the upfront premium payment, the breakeven point (the point where the gains begin), and the leverage of the given risk. If the market participant has limited funds to spend on the premium, then an out-of-the-money strike, which is relatively inexpensive, reflecting less protection and higher leverage will be chosen. Thus, the purchaser is willing to accept less protection because of a strong view that the dollar value will increase. The breakeven point will not be as favourable as a strike that is further in-the-money because it will represent the premium and the difference between the forward rate and the strike.