Foreign Exchange Financial Engineering
Trade a Long Currency Position with a Purchased Knock Out Call
• • • • DRAFT Unlimited Benefit when Currency Appreciates Loss Limited to Premium Paid Reduced Upfront Cost vs. Vanilla Call Profile of a Purchased Knock Out Call to Trade a Long Currency Position
Profit Range with No Trigger Event Option PremiumCos t Range
Product Description A knock out call has all of the features of a vanilla call with the addition of a knock out trigger that renders the option null and void if spot trades at or through the trigger level. If spot never trades at the trigger, a trader with a short currency position has unlimited profit potential if the currency depreciates. If spot should depreciate to the knock out level prior to the contract expiration, the option disappears regardless of where spot trades thereafter. As is the case with all purchased options, the trader’s risk of loss is limited solely to the premium paid. Knock Out Call Options as a Trade A trader with a appreciating currency view would purchase a knock out call to reap most of the benefits of a purchased vanilla call option. The benefit of adding a knock out reduces the trade cost and brings the break even rate closer to the call strike. The drawback to this strategy is the risk of losing the position should the currency depreciate to the trigger prior to the contract expiration.
Position Value with Trigger Event
+
P & L
0
Trigger Level
Purchased Call Strike
Foreign Currency
Forward Position Value with No Trigger Event
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Currency View Very Bullish Bullish Neutral Bearish Very Bearish Volatile Market Conditions Currency Foreign Interest Rates Domestic Interest Rates Implied Volatility Market Place Frequency Liquidity
Trade Performance Inferior......................Superior
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Traders usually set four of the five primary components of the trade: the call strike, the trigger level, the notional amount and maturity. The strategy seller will then calculate the premium cost. Since the distance between the trigger and the strike dictates the premium cost and the risk/reward profile, increasing or decreasing this distance makes the premium cheaper or more expensive. If a trader wants to pay a lower premium and has a strong appreciating currency view in a market with low actual volatility, the most common change to the initial parameters is to set the trigger level closer to the money. This change increases the likelihood of spot trading to the trigger level and increases the potential that the trader may lose the premium. However, should the currency depreciate, the trader’s break even will be much closer to the market. If the trader wants to decrease risk by decreasing the likelihood of being knocked out of the strategy, the trigger usually moves further OTM. Reduced risk isn’t free, however, so the strategy cost goes up. In fact, the further the trigger level moves OTM, the more the option and its cost will resemble a vanilla call. Since this option knocks out when it’s OTM, many traders view this as a preferable risk given that the vanilla call would also be OTM and worthless. The major difference between the two is the plain vanilla call without a knock out affords the trader the chance to profit should spot bounce.
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