OPTION STRATEGIES in

CURRENCIES
Chetna joshi
Abhishek oberai
Shakti Rajpal
Ravinder Kr. Goyal
 Barrier options
Barrier options belong to the category of exotic options – extremely popular
among forex option traders – meaning that they possess a component other than
the expiry date and the strike price. Regarding barrier options, the additional
component is the trigger – or the barrier – which if reached either brings the
option into being (knock in option) or cancels it (knock out option). You thus
choose a strike price as well as a trigger. Since there is a chance that these
options may never come into effect or may be canceled, they are generally
cheaper that their vanilla counterpart
Knock in
A knock-in option becomes a regular option (it is "knocked
in”) if and when the trigger price is met before the expiration
date.
This means that if the rate is never reached, the contract is
canceled and the buyer loses the premium. If the barrier rate is
met, then the option starts running like a regular put or call
option.
Knock-in options are less expensive than regular options since
they have an additional conditional component that cheapens
the price of the premium.
The further the barrier to the spot rate, the cheaper the
premium, since there is a lesser chance that the option will be
knocked in before the expiration date.
Knock out
The knock out option will automatically cease to exist and expire worthless
(it will be "knocked out”) if and when the trigger price is reached before
the expiration date.
If the rate never hits the barrier, the knock out option runs the same way as
a regular option.
For a call knock-out option, the trigger is set below the spot rate, and above
for a put (out-of-the-money).
The higher the implied volatility, the greater the chance the barrier being
triggered and the option being knocked out.
Knock-out options are cheaper than regular put or call option (vanilla)
since they may be knocked out before expiry.
The premium gets cheaper as the barrier gets closer to the spot rate since
the option has a greater chance of being knocked out. Since the option
ceases to exist, there is no payoff even if the price moves back within the
knock-out barrier before the original expiration.
Up and out or knock out put option
Consider a european put on USD against rupee at a strike
price of Rs. 45 per dollar.
The condition is that the option ceases to exist or is
knocked out if the usd/rupee goes above 48 at any time
during the life of the option irrespective of what the spot
rate is on the expiry date, it becomes an up-and-out put
option. An Indian exporter with a dollar receivable might
buy such an option to protect the dollar value of its assets.
Up-and-in put option
This is opposite of up-and-out put. Here the option comes into
existence if the spot rate goes above a certain level. In the previous
example , a put with a strike of Rs. 45, and a condition that the put
becomes effective only if the spot rate goes above Rs. 48 makes it a
up-and-in put. If the rate never goes above the barrier level before
expiry date, the put never comes into existence.

The hedger or trader might use this option if the outlook for USD is
bullish in the short-to-medium-run but bearish in the long-run.
Down-and-out call
This is a call with a condition that the option ceases to exist if the spot
rate moves below the barrier level.

For ex. A Indian firm with USD payable might buy a call on USD
with a strike price of Rs. 45 per USD with a knock out at Rs. 42. as
soon as the spot price touches the barrier of 42, it gets knocked out.
Down-and-in call option
This is opposite of down-and-out call. The down-and-in call comes
into existence only if the spot rate moves below the barrier level.

This option will be used when the view is bearish in the short-term but
bullish in the long-run.

A Indian firm with USD payable might buy a call on USD with a
strike price of Rs. 45 per USD with a knock in at Rs. 42. as soon as the
spot price touches the barrier of 42, it comes into existence.
Reverse knock out
The difference between a knock out option and a reverse knock out
option lies in the localization of the trigger barrier.

Whereas with a regular knock out, the trigger is set out-of-the-money

(meaning below the spot rate for a call and above for a put), with a
RKO, the trigger is set in-the-money (above the spot rate for a call and
below for a put).
Reverse knock in
The difference between a knock in option and a reverse knock in
option lies in the localization of the trigger barrier. Whereas the trigger
is out-of-the money for a knock in, it is in-the-money for a RKI.
Up-and-out call option
A customer believes that the EUR will strengthen somewhat versus the
USD. In an effort to reduce the premium but still reflect the view, the
customer buys a EUR15 million, 3 month 0.9500 EUR Call with a KO
at 1.0100 (Spot Reference: 0.9250)

If 1.0100 never trades over the life of the option and:

spot at expiry is above 0.9500, the customer buys EUR and sells USD
at 0.9500
spot at expiry is below 0.9550, the option expires worthless

If 1.0100 trades at any time during the life of the option, then the
option is terminated.
Up-and-in call
A customer believes the EUR will appreciate against the USD. He
feels the move will be large and would like to reduce the premium
cost. The customer buys a EUR 15 million 3 month 0.9400 EUR Call
with a KI at 1.0200{Spot Reference: 0.9250}.

If 1.0200 never trades during the life of the KI option, then no option
is created and the contract expires worthless.
If 1.0200 trades, then the customer becomes long a 0.9400 EUR
Call/USD Put and can manage the position accordingly based on his
view.
Reverse knock out put- down and
out put option
Consider a European put on USD against rupee at a strike price of Rs.
45 per dollar.

The condition is that the option ceases to exist or is knocked out if the
barrier of Rs.42 is reached at any time during the life of the option
irrespective of what the spot rate is on the expiry date, it becomes an
down-and-out put option.
Down-and-in put option
This is opposite of down-and-out put. Here the option comes into
existence if the spot rate goes down a certain level.

Consider a European put on USD against rupee at a strike price of Rs.

45 per dollar.

The condition is that the option comes into existence or is knocked in

if the barrier of Rs.42 is reached at any time during the life of the
option irrespective of what the spot rate is on the expiry date, it
becomes an down-and-in put option.
Range forward
Have the effect of ensuring that exchange rate paid or
received will lie within a certain range.

Exporter- buy put at strike price which is less than the

forward exchange rate and sell call at the price greater than
the forward exchange rate.

Importer- buy call at strike price which is greater than the

forward exchange rate and sell put at the price less than the
forward exchange rate

Normally the price of the put equals the price of the call
Cont…
Consider a Indian exporter that knows it will receive one million
dollar in three months. Suppose that three month forward exchange
rate is 45rs per dollar. To cover the exchange risk, exporter can buy a
put option with a strike price 42 (k1) and sell a call option with a strike
price 48 (k2). This is known as short forward contract.
If the exchange rate proves to be less than 42, put option is
exercised. If the exchange rate is between 42 and 48, neither option is
exercised. If exchange rate is greater than 48 call option is exercised.
Cont…..
Payoff
Payoff

Asset
Price
K1 K2 K1 K2 Asset
Price

Exporter Importer
Barrier options built into range
forward
A company with dollar inflows and euro outflows enters into the
following deal. The current EUR/USD spot- 0.8720, 6 month forward
– 0.8792.
The face amount of the deal is EUR 1 million. The payoffs are as
follows:
A) if the spot rate never touches 0.8288 or 0.9300 during the life of the
option then if at maturity, the spot rate is below 0.8700 but above
0.8288, the customer buys EUR and sells USD at 0.8700. if the
maturity spot is between 0.8700 and 0.8892, the customer buys EUR
at market, and if the spot is above 0.8892 but below 0.9300, customer
buys at 0.8892. this is exactly like the range forward contract.
B) if the spot remains above 0.8288 but 0.9300 is seen during the life of the option : if
the maturity spot is between 0.8288 and 0.8700, the customer buys EUR at 0.8700. if the
maturity spot is at or above 0.8700, customer pays the market spot.

C) if the spot remains below 0.9300 but 0.8288 is seen during the life of the option: if the
spot rate at maturity is at or above 0.8892 but below 0.9300, the customer pays USD
0.8892 per EUR. If the maturity spot is below 0.8892, the customer pays the market rate.

D) if both 0.8288 and 0.9300 are seen during the life of the option, the customer buys at
maturity spot.

Customer pays no premium up-front.

The structure can be constructed as follows:

The client buys a European call on EUR, strike rate 0.8892, with an up-and-out
barrier at 0.9300 and sells a European put to the bank, strike rate 0.8700 with a
down-and-out barrier at 0.8288. if the exchange rate stays within the barriers
0.8288 and 0.9300, this structure works like a range forward with 0.8892 and
0.8700 as the ceiling and floor, as in case (a) .

If 0.9300 is touched but not 0.8288, the customer’s call gets knocked out while
the bank’s put remains alive (case b),
If 0.8288 is touched but not 0.9300, the bank’s put gets knocked out but the
customer’s call remains alive (case c), and
If both the barriers are touched, both the options get knocked out and customer
buys at market at maturity (case d).
Bermuda option
Bermuda options have an exercise option that is somewhat between that of
American- and European-style options. (Supposedly, the name Bermuda
derives from the island’s location between the United States and Europe.)

Whereas an American-style option can be exercised any time before

expiration and a European option can only be exercised on or near the
expiration date, a Bermuda option can only be exercised on specific days
before expiration or on the expiration date.

For instance, a Bermuda option may allow exercise only on the 1st day of
each month before expiration, or on expiration.

Such options are more expensive than standard options.

Binary Options or Digital options or
All or Nothing Options
These were created to eliminate the complexities of traditional Call
Put Options.

Two Types: Cash or nothing Call

Cash or Nothing Put

Cash or Nothing Call pays off nothing if the asset rice ends up below
the strike price at a time T and Pays a fixed amount Q, if ends up
above the strike price.
Cont……
Cash or Nothing Put Pays off Q if the asset price is below the
strike price and nothing if it is above the strike price.

For E.g : Cash or Nothing Call

Imagine you are a trader who is willing to trade options and risk
1 dollar on the idea that Euro/Dollar’s exchange rate will move
higher in one hour from now. If your guess is correct, you can
anticipate a fixed return on your investment (70% for example).
On the contrary, if your binary Euro/Dollar option move against
your anticipation (below the strike price), you will end up
losing your initial investment of 1$ and get a zero dollars
return.
Cont……
In Binary Options, One only bet on the performance of currency, not actually
own the currency.

If one expects the currency rate (asset) to go up from strike price, he will buy
cash or nothing call.

If one expects the currency rate (asset) to go down from strike price, he will
buy cash or nothing Put.

In these, Trader knows the exact maximum risk and maximum profit.
Thank you