Banks that sold a European-style dollar/yen double no-touch barrier option with a payout of some USD20-50 million were scrambling last week to cover their exposure as the option looked increasingly likely to expire in the money. Traders said firms short the option have been active selling strangles, in which they sell dollar calls/yen puts struck at the upper barrier and sell dollar puts/yen calls struck at the lower barrier, in order to generate premium in the event the barrier option expires in the money.
Lehman Brothers is rumored to have bought the barrier option on behalf of a client, according to several traders. However, sellers of the double no-touch could not be determined. Cameron Millar, global head of fx options at Lehman in London, declined comment.
The one-month no-touch is set to expire Feb. 26, according to fx options traders. The barriers are set at JPY131.35 and JPY135.50 and spot was trading at JPY132.85 last Thursday. Spot was at JPY131.45 when the option was sold. When it was first put on traders did not think it would end in the money. One said, "it had about a two percent chance, but now it's looking pretty good."
Around USD300 million in one-month strangles with strikes at the same level as the barriers have been sold in the last week, dealers said. The strikes on the strangles suggests these trades are directly related to the barrier option.
The activity has pushed dollar/yen implied volatility down to 9.5% from 10% at the start of the month and has even pushed down euro/dollar vol 50 basis points to 8.5%. "This is weighing on the whole options market," said one trader, adding the payout appears to be in the range of USD50 million because of the amount of hedging.
Foreign exchange professionals called Lehman's position, even at the low end of estimates, an exceptionally large amount. "These trades tend to be in lots of USD2-3 million each. This is a big, big deal," said one options trader at a top fx house. Traders said the premium for the double no-touch would be about 10%, or USD1-5 million. "I think my mum even knows the barriers," quipped one trader.
