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Derivatives

Exotic Options Trading Keeps Euro Dollar In Range

Hedge funds and other sophisticated traders were buying exotic options, such as reverse knockouts, on the euro and U.S. dollar currency pair last week with the effect of preventing the dollar from weakening further in the spot market.

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Hedge funds and other sophisticated traders were buying exotic options, such as reverse knockouts, on the euro and U.S. dollar currency pair last week with the effect of preventing the dollar from weakening further in the spot market. Euro/dollar spot was trading at USD1.2385 and traders said the weight of options struck at USD1.25 was keeping it in this range, although it had broken through earlier barriers at USD1.23 and USD1.22. One-month implied volatility continued on its downward path to hit 9.9% last Tuesday, it was 11.6% at the beginning of June.

Funds were typically buying reverse knockout structures, with one-week to one-month euro calls/dollar puts struck at USD1.25 with knockouts at around 1.2850. These trades are popular because they are a cheap way of expressing a view on the dollar's decline, explained a structurer. "A call with a knockout is maybe 20% of the cost [of the equivalent vanilla call option]," he added. Traders expect the euro to appreciate slowly and said these trades are ideal in this scenario because the options lose a lot of their value in the case of big jump in the underlying, even if they don't breach the knockout rate.

Tony Norfield, currency strategist at ABN AMRO in London, suggested the low-volatility period could be over in a few months. "Volatility could rise with a range break on the euro upside," he said. The currency pair may stick at USD1.25 or USD1.26 because of low confidence in the European economy, added Norfield.

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