OPTION STRATEGIES in CURRENCIES

Chetna joshiAbhishek oberai

Shakti RajpalRavinder Kr. Goyal

Barrier options

Barrier options belong to the category of exotic options – extremely popular among forex option traders – meaning that they possess a component other than the expiry date and the strike price. Regarding barrier options, the additional component is the trigger – or the barrier – which if reached either brings the option into being (knock in option) or cancels it (knock out option). You thus choose a strike price as well as a trigger. Since there is a chance that these options may never come into effect or may be canceled, they are generally cheaper that their vanilla counterpart

Knock inA knock-in option becomes a regular option (it is "knocked in”) if and when the trigger price is met before the expiration date. This means that if the rate is never reached, the contract is canceled and the buyer loses the premium. If the barrier rate is met, then the option starts running like a regular put or call option. Knock-in options are less expensive than regular options since they have an additional conditional component that cheapens the price of the premium. The further the barrier to the spot rate, the cheaper the premium, since there is a lesser chance that the option will be knocked in before the expiration date.

Knock outThe knock out option will automatically cease to exist and expire worthless (it will be "knocked out”) if and when the trigger price is reached before the expiration date. If the rate never hits the barrier, the knock out option runs the same way as a regular option.For a call knock-out option, the trigger is set below the spot rate, and above for a put (out-of-the-money).The higher the implied volatility, the greater the chance the barrier being triggered and the option being knocked out. Knock-out options are cheaper than regular put or call option (vanilla) since they may be knocked out before expiry. The premium gets cheaper as the barrier gets closer to the spot rate since the option has a greater chance of being knocked out. Since the option ceases to exist, there is no payoff even if the price moves back within the knock-out barrier before the original expiration.

Up and out or knock out put option

Consider a european put on USD against rupee at a strike price of Rs. 45 per dollar.

The condition is that the option ceases to exist or is knocked out if the usd/rupee goes above 48 at any time during the life of the option irrespective of what the spot rate is on the expiry date, it becomes an up-and-out put option. An Indian exporter with a dollar receivable might buy such an option to protect the dollar value of its assets.

Up-and-in put optionThis is opposite of up-and-out put. Here the option comes into existence if the spot rate goes above a certain level. In the previous example , a put with a strike of Rs. 45, and a condition that the put becomes effective only if the spot rate goes above Rs. 48 makes it a up-and-in put. If the rate never goes above the barrier level before expiry date, the put never comes into existence.

The hedger or trader might use this option if the outlook for USD is bullish in the short-to-medium-run but bearish in the long-run.

Down-and-out callThis is a call with a condition that the option ceases to exist if the spot rate moves below the barrier level.

For ex. A Indian firm with USD payable might buy a call on USD with a strike price of Rs. 45 per USD with a knock out at Rs. 42. as soon as the spot price touches the barrier of 42, it gets knocked out.

Down-and-in call optionThis is opposite of down-and-out call. The down-and-in call comes into existence only if the spot rate moves below the barrier level.

This option will be used when the view is bearish in the short-term but bullish in the long-run.

A Indian firm with USD payable might buy a call on USD with a strike price of Rs. 45 per USD with a knock in at Rs. 42. as soon as the spot price touches the barrier of 42, it comes into existence.

Reverse knock outThe difference between a knock out option and a reverse knock out option lies in the localization of the trigger barrier.

Whereas with a regular knock out, the trigger is set out-of-the-money (meaning below the spot rate for a call and above for a put), with a RKO, the trigger is set in-the-money (above the spot rate for a call and below for a put).

Reverse knock inThe difference between a knock in option and a reverse knock in option lies in the localization of the trigger barrier. Whereas the trigger is out-of-the money for a knock in, it is in-the-money for a RKI.

Up-and-out call optionA customer believes that the EUR will strengthen somewhat versus the USD. In an effort to reduce the premium but still reflect the view, the customer buys a EUR15 million, 3 month 0.9500 EUR Call with a KO at 1.0100 (Spot Reference: 0.9250)

If 1.0100 never trades over the life of the option and: spot at expiry is above 0.9500, the customer buys EUR and sells USD at 0.9500 spot at expiry is below 0.9550, the option expires worthless

If 1.0100 trades at any time during the life of the option, then the option is terminated.

Up-and-in callA customer believes the EUR will appreciate against the USD. He feels the move will be large and would like to reduce the premium cost. The customer buys a EUR 15 million 3 month 0.9400 EUR Call with a KI at 1.0200{Spot Reference: 0.9250}.

If 1.0200 never trades during the life of the KI option, then no option is created and the contract expires worthless. If 1.0200 trades, then the customer becomes long a 0.9400 EUR Call/USD Put and can manage the position accordingly based on his view.

Reverse knock out put- down and out put option

Consider a European put on USD against rupee at a strike price of Rs. 45 per dollar.

The condition is that the option ceases to exist or is knocked out if the barrier of Rs.42 is reached at any time during the life of the option irrespective of what the spot rate is on the expiry date, it becomes an down-and-out put option.

Where A- strike price= Rs. 45 & B- Barrier= Rs. 42

Down-and-in put optionThis is opposite of down-and-out put. Here the option comes into existence if the spot rate goes down a certain level.

Consider a European put on USD against rupee at a strike price of Rs. 45 per dollar.

The condition is that the option comes into existence or is knocked in if the barrier of Rs.42 is reached at any time during the life of the option irrespective of what the spot rate is on the expiry date, it becomes an down-and-in put option.

Range forwardHave the effect of ensuring that exchange rate paid or received will lie within a certain range.

Exporter- buy put at strike price which is less than the forward exchange rate and sell call at the price greater than the forward exchange rate.

Importer- buy call at strike price which is greater than the forward exchange rate and sell put at the price less than the forward exchange rate

Normally the price of the put equals the price of the call

Cont…

Consider a Indian exporter that knows it will receive one million dollar in three months. Suppose that three month forward exchange rate is 45rs per dollar. To cover the exchange risk, exporter can buy a put option with a strike price 42 (k1) and sell a call option with a strike price 48 (k2). This is known as short forward contract.

If the exchange rate proves to be less than 42, put option is exercised. If the exchange rate is between 42 and 48, neither option is exercised. If exchange rate is greater than 48 call option is exercised.

Cont…..Payoff

Asset Price

K1 K2

Payoff

Asset Price

K1 K2

Exporter Importer

Barrier options built into range forward

A company with dollar inflows and euro outflows enters into the following deal. The current EUR/USD spot- 0.8720, 6 month forward – 0.8792.

The face amount of the deal is EUR 1 million. The payoffs are as follows:

A) if the spot rate never touches 0.8288 or 0.9300 during the life of the option then if at maturity, the spot rate is below 0.8700 but above 0.8288, the customer buys EUR and sells USD at 0.8700. if the maturity spot is between 0.8700 and 0.8892, the customer buys EUR at market, and if the spot is above 0.8892 but below 0.9300, customer buys at 0.8892. this is exactly like the range forward contract.

B) if the spot remains above 0.8288 but 0.9300 is seen during the life of the option : if the maturity spot is between 0.8288 and 0.8700, the customer buys EUR at 0.8700. if the maturity spot is at or above 0.8700, customer pays the market spot.

C) if the spot remains below 0.9300 but 0.8288 is seen during the life of the option: if the spot rate at maturity is at or above 0.8892 but below 0.9300, the customer pays USD 0.8892 per EUR. If the maturity spot is below 0.8892, the customer pays the market rate.

D) if both 0.8288 and 0.9300 are seen during the life of the option, the customer buys at maturity spot.

Customer pays no premium up-front.

The structure can be constructed as follows:

The client buys a European call on EUR, strike rate 0.8892, with an up-and-out barrier at 0.9300 and sells a European put to the bank, strike rate 0.8700 with a down-and-out barrier at 0.8288. if the exchange rate stays within the barriers 0.8288 and 0.9300, this structure works like a range forward with 0.8892 and 0.8700 as the ceiling and floor, as in case (a) .

If 0.9300 is touched but not 0.8288, the customer’s call gets knocked out while the bank’s put remains alive (case b), If 0.8288 is touched but not 0.9300, the bank’s put gets knocked out but the customer’s call remains alive (case c), andIf both the barriers are touched, both the options get knocked out and customer buys at market at maturity (case d).

Bermuda optionBermuda options have an exercise option that is somewhat between that of American- and European-style options. (Supposedly, the name Bermuda derives from the island’s location between the United States and Europe.)

Whereas an American-style option can be exercised any time before expiration and a European option can only be exercised on or near the expiration date, a Bermuda option can only be exercised on specific days before expiration or on the expiration date.

For instance, a Bermuda option may allow exercise only on the 1st day of each month before expiration, or on expiration.

Such options are more expensive than standard options.

Binary Options or Digital options or All or Nothing Options

These were created to eliminate the complexities of traditional Call Put Options.

Two Types: Cash or nothing Call

Cash or Nothing Put

Cash or Nothing Call pays off nothing if the asset rice ends up below the strike price at a time T and Pays a fixed amount Q, if ends up above the strike price.

Cont……Cash or Nothing Put Pays off Q if the asset price is below the strike price and nothing if it is above the strike price.

For E.g : Cash or Nothing Call Imagine you are a trader who is willing to trade options and risk

1 dollar on the idea that Euro/Dollar’s exchange rate will move higher in one hour from now. If your guess is correct, you can anticipate a fixed return on your investment (70% for example). On the contrary, if your binary Euro/Dollar option move against your anticipation (below the strike price), you will end up losing your initial investment of 1$ and get a zero dollars return.

Cont……In Binary Options, One only bet on the performance of currency, not actually own the currency.

If one expects the currency rate (asset) to go up from strike price, he will buy cash or nothing call.

If one expects the currency rate (asset) to go down from strike price, he will buy cash or nothing Put.

In these, Trader knows the exact maximum risk and maximum profit.

Thank you