Exotic FX options and options barriers

A good explanation of exotic FX options from Jamie Coleman at www.forexlive.com (a great news source)

Exotic options

The last decade has seen exotic options rise to prominence. The impact of these options has mirrored the rise of China as a financial superpower. China uses these options in massive size at times when they want to drain the market of volatility. Rather than merely entering the forex market to diversify their massive dollar holdings into EUR or GBP, they also actively trade the market, often in conjunction with their considerable options portfolio. One of their favorite strategies is to purchase something called double-no-touches.

Why do speculators like strategies like the DNT? They tend to have an attractive risk/reward ratio. Putting up $1 in premium typically brings $5 in payouts if the trade is successful.

Let’s define terms: A double-no-touch (DNT) is a strategy that pays the owner of the structure so long as the spot price does not touch either of the predetermined strike prices before expiry. As long as prices stay within the predefined range, the trade is a winner for the buyer and a loser for the writer, or seller, of the structure. The tighter the range specified, the smaller the premium, as the odds of staying with a tight range are smaller than a wide range. The buyer puts up a fraction of the potential payout up front and receives a multiple of the wager if prices don’t violate the range.

At present, China is rumored to be sitting on a 1.3350/1.3850 double-no-touch, which comports with recent price action.
The incentives for the counterparties in these trades are diametrically opposed. The buyer wants to maintain the range to keep his structure alive until expiry. If it exceeds the range by even one pip, it is “knocked out”.

How is that tension manifested in the market? Often, by a fearsome two-way battle. Let’s say for the sake of illustration, the base of a 1.3350/1.3850 DNT is in play. What sort of price action can we expect? Typically, the owner of the option structure will want to preserve his investment and may be willing to take some risk to do so. He’ll do that by trying to support the market and prevent it from slipping to the 1.3350 level where he would be knocked out.

The writer, or seller, of the DNT will often take a fair bit of risk to try and push the market outside the range covered by the option. Why? Because the writer has even greater risk than the owner of the DNT. The owner may have risked $5 million to put the strategy in place for the opportunity to “win” $20 million, for example. Even if the bank which sold the option loses money on the spot trade needed to force the price out of the range, he eliminates the risk of having to make a $20 mln payout. The volumes turned over near these strike prices can be huge because the stakes can be so high.

Sophisticated investors with deep pockets can defend specific levels and make large profits if successful. For example, if the market is very short with traders looking to push the market below a barrier (or knockout or trigger, these terms are all interchangeable) in search of stop-loss orders or to break a technical support level but fails, the defender of the option has bought large amounts at the bottom of the market. Our Asian friend will often hold those positions for about a penny and a half before selling them back into the market, just as traders are starting to get bullish again after a bottom was put in place just ahead of 1.3350.

Next thing you know, the market is sliding again and the 1.3350 level comes back into focus. The whole process is repeated again. Often the positions acquired in these “defensive” operations are in the hundreds of millions of euros (or dollars, or AUD, etc, depending on the market). A few “round trips” and whether or not the option position is profitable becomes irrelevant. The defense makes huge profits all on its own, if successful.

What does the price action look like when option defense fails?
How often have you seen the market slip through a much-talked about level by a few pips only to turn around and rally strongly? Likely the culprit is an effort to trigger a barrier. If Bank A sold 500 mln EUR/USD to force the market lower and extinguish barrier options, it has to quickly turn around and cover that short, leading to whipsaw price action. It avoids the huge payout but could get hurt if it can’t cover its short profitably.

ForexLive is one of the few places where traders can pick up information of exotic options that are in play. We try and alert traders to these structures so they do not get caught selling what looks like a breakout only to see the market quickly reverse field.