Double No Touch FX Option Strategies for Low Volatility Markets: A Case Study. Udi Sela September 2012
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1 Double No Touch FX Option Strategies for Low Volatility Markets: A Case Study Udi Sela September 2012
2 About the Speaker Udi Sela has been active in foreign exchange derivatives markets over the last 18 years. A senior derivatives trader and trading manager at Citibank and JPMorgan, developed expertise in derivatives spanning both vanilla and complex FX options. During the last seven years led product development and pre-sales functions within a range of financial software vendors. He holds an MBA in Finance and Technology Management.
3 Key Message Option strategies undertaken are determined by the level of volatility in the market. The current environment of historically low volatilities suggests that an examination of alternative very specific options strategies could be profitable.
4 Agenda Brief introduction of current low Volatility Traditional strategies to trade Volatility Double No Touch options European Range Bet option DNT in emerging markets Summary Q&A
5 USD/JPY Spot Rate History
6 Volatility A year ago: Three months Implied Volatility traded around 11% The Spot three month Historical Vol was around 9.5% Today (as of August): Three months Implied Vol trades around 7.5% The Spot three month Historical Vol is around 6.4% (lowest levels in the past five years)
7 Selling Volatility Traditional Strategies (USD/JPY) Sell a Straddle - two options: USD Call plus USD Put USD/JPY Both struck at the money (zero Delta Straddles) 10 Million Dollar a leg Expiry in three month Premium received 293,000 USD
8 Selling a Straddle: USD/JPY
9 Selling a Straddle (USD/JPY): Risks Limited profit (premium) Potential unlimited loss Mark-to-market losses Short Gamma expensive hedging (for those choosing the hedge, typically sell-side players)
10 Risk Analysis Selling USD/JPY Straddle Increased loss as Spot rate moves significantly either way Short Gamma mostly across the Strike Prices Short Vega Need to take a look at Time Horizon as well
11 Sell Volatility Selling USD/JPY Strangle Sell a Strangle: USD Put struck at 76 USD Call struck at Million Dollar a leg Expiry in three month Premium received 95,500 USD
12 Selling a Strangle (USD/JPY)
13 Selling a Strangle (USD/JPY): Risks Limited profit (premium) Potential unlimited loss Mark-to-market losses Short Gamma expensive hedging (when performing dynamic hedging) Lower risk as opposed to Straddle (Strike prices are further out of the money) Premium of strategy is lower than Straddle
14 Risk Analysis (Selling USD/JPY Strangle) Increased loss as Spot rate moves significantly either way Short Gamma mostly across the Strike Prices Short Vega Need to take a look at Time Horizon as well
15 Straddle / Strangle Comparison (USD/JPY) Straddle Premium received $293,000 Strategy in the Money as the market moves away from Short Vega ($40,000) Short Gamma ($2,000,000) Strangle Premium received $95,500 Strategy in the Money if market trades below 76 or above 81 Short Vega ($29,000) Short Gamma ($1,400,000)
16 Sell Volatility USD/JPY Buy a Double No Touch option Receive 1,000, 000 USD if: Market doesn t trade any day till expiry at or below Or 81 and above Expiry in three month Premium to be paid 230,000 USD
17 Buying a DNT USD/JPY
18 Buying a DNT Option (USD/JPY) Limited Loss (premium) Potential profit 1,000,000 USD (four times over premium paid) Potential Mark-to- Market losses Premium paid in advance (upon inception date)
19 Risk Analysis (DNT USD/JPY) If towards expiry the Spot rate trades near the triggers, Delta and Gamma become very high Vega diminishes over time
20 USD/JPY DNT Delta Differences
21 USD/JPY DNT Gamma Differences
22 USD/JPY DNT Vega Differences
23 Sell Volatility USD/JPY Buy a European Range Bet option: Receive 1,000, 000 USD ONLY if at expiry: Market doesn t trade at or below Or 81 and above Expiry in three month Premium to be paid 558,000 USD
24 Buying an European Range Bet Option
25 Buying a USD/JPY ERB Option Limited Loss (premium) Potential profit 1,000,000 USD (almost twice over premium paid) Potential Mark-to- Market losses Premium paid in advance (upon inception date) Lower probability of range being breached
26 Risk Analysis USD/JPY ERB Very similar to DNT s risk profile If towards expiry the Spot rate trades near the triggers, Delta and Gamma increase to extreme levels (well above DNT), due to additional leverage effect
27 Sell Volatility USD/ZAR Buy a Double No Touch option in an emerging market - Higher Implied Volatility USD/ZAR Receive 1,000, 000 USD if: Market doesn t trade any day till expiry at 7.95 or below Or 8.95 and above Expiry in three month Premium to be paid 230,000 USD
28 USD/ZAR DNT Option
29 Buying a DNT Option in an Emerging Market (USD/ZAR) Limited Loss (premium) Better leverage ratio or wider range Potential profit 1,000,000 USD (four times over premium paid) Potential Mark-to- Market losses Premium paid in advance (upon inception date)
30 Risk Analysis As the option has a high time value, please note the Theta As the Volatility of the pair is much higher, the risk of hitting the barriers is higher as well Better risk reward/ratio but lower probability of a payoff at expiry
31 USD/ZAR Spot Rate
32 USD/ZAR 3M Implied Volatility
33 Strategies MTM Three Weeks Later
34 Choice of Underlying Assets JPY: Perceived as a safe haven currency Bank of Japan supporting US Dollar below ZAR: High Volatility currency High negative correlation with Euro (around -0.7)
35 Summary The current environment (Northern summer months) has been characterized by low volatility Various trading techniques are available to benefit from expected low volatility Traditional strategies entail unlimited risk in case of sudden violent moves Buying DNT limits the potential loss to the premium paid The implied volatility of the underlying asset determines the risk/reward profile
36 Technical Note The examples used in this presentation were provided by the OTC derivatives pricing platform dfferentia, found at This software platform is powered by the financial models and methods developed at Numerix, found at This software is available to financial markets participants and can be readily used to identify and undertake these and other profitable strategies available in the OTC markets
37 Questions and Answers
38 About Numerix Numerix provides cross-asset analytics software and services for structuring, pre-trade pricing and analysis, trade capture, valuation, and risk management of derivatives and structured products. Visit us online at: Contact us at:
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