As traders anticipated euro/dollar spot would climb to parity or higher and implied volatility reached approximately 12.9% last week, foreign exchange strategists were recommending knockouts to various users of fx options. On Wednesday, when spot was trading at USD0.99, Lehman Brothers was recommending a switching-knockout trade, primarily for speculators, which consists of a one-month euro call struck at USD0.995, where the knockout is at USD1.0250 for the first two weeks and at USD0.975 in the following two weeks. The end user benefits in this trade if the euro does not trade at or above 1.0250 in the first two weeks and does not trade at or below USD0.975 in the following two weeks. It is based on the view that euro/dollar spot will first enter a consolidation phase before re-entering its upward trend, saidEric Ohayon, head of fx structuring at Lehman. The upfront premium for this trade is 60 basis points over the reference spot rate, compared with a one-month euro call at USD0.995, priced at 125bps over that rate, he said.
Shahab Jalinoos, fx strategist at UBS Warburg, is recommending that investors purchase a euro call with a strike at USD1.03 and a knockout at USD1.07. Meanwhile, ABN AMRO told investors that purchasing a European reverse knockout euro call/dollar put would protect against further dollar downside while minimizing premium. Rob Hayward, foreign exchange strategist at ABN, explained the trade, based on a USD0.9895 spot rate, would have a euro call/dollar put strike at USD1, with the knockout at USD1.05 and a one-month expiry. The option only ceases to exist in this trade if spot is above USD1.05 at the expiry--if it trades through that level and then retraces, the option is still in place. This gives investors the potential to profit from a rise in the euro above USD1 up to USD1.0499, even if there is a volatile spike in the price at some point over that time period. The cost of this is 64bps plus the cost of dollar spot, compared with 150bps for the plain vanilla trade, Hayward said.
