Q. Barrier options: What purpose do they serve, and why do people use them?

Please note: This piece is recycled from an earlier presentation. Market prices are for illustration only. They do not apply to present market conditions.

A. The last decade has seen exotic options rise to prominence. The impact of these options has mirrored the rise of China as a financial superpower. China uses these options in massive size at times when they want to drain the market of volatility. Rather than merely entering the forex market to diversify their massive dollar holdings into EUR or GBP, they also actively trade the market, often in conjunction with their considerable options portfolio. One of their favorite strategies is to purchase something called double-no-touches.

Why do speculators like strategies like the DNT? They tend to have an attractive risk/reward ratio. Putting up $1 in premium typically brings $5 in payouts if the trade is successful.

Let’s define terms: A double-no-touch (DNT) is a strategy that pays the owner of the structure so long as the spot price does not touch either of the predetermined strike prices before expiry. As long as prices stay within the predefined range, the trade is a winner for the buyer and a loser for the writer, or seller, of the structure. The tighter the range specified, the smaller the premium, as the odds of staying with a tight range are smaller than a wide range. The buyer puts up a fraction of the potential payout up front and receives a multiple of the wager if prices don’t violate the range.

At present, China is rumored to be sitting on a 1.3350/1.3850 double-no-touch, which comports with recent price action.

The incentives for the counterparties in these trades are diametrically opposed. The buyer wants to maintain the range to keep his structure alive until expiry. If it exceeds the range by even one pip, it is “knocked out”.

How is that tension manifested in the market? Often, by a fearsome two-way battle. Let’s say for the sake of illustration, the base of a 1.3350/1.3850 DNT is in play. What sort of price action can we expect? Typically, the owner of the option structure will want to preserve his investment and may be willing to take some risk to do so. He’ll do that by trying to support the market and prevent it from slipping to the 1.3350 level where he would be knocked out.

The writer, or seller, of the DNT will often take a fair bit of risk to try and push the market outside the range covered by the option. Why? Because the writer has even greater risk than the owner of the DNT. The owner may have risked $5 million to put the strategy in place for the opportunity to “win” $20 million, for example. Even if the bank which sold the option loses money on the spot trade needed to force the price out of the range, he eliminates the risk of having to make a $20 mln payout. The volumes turned over near these strike prices can be huge because the stakes can be so high.

Sophisticated investors with deep pockets can defend specific levels and make large profits if successful. For example, if the market is very short with traders looking to push the market below a barrier (or knockout or trigger, these terms are all interchangeable) in search of stop-loss orders or to break a technical support level but fails, the defender of the option has bought large amounts at the bottom of the market. Our Asian friend will often hold those positions for about a penny and a half before selling them back into the market, just as traders are starting to get bullish again after a bottom was put in place just ahead of 1.3350.

Next thing you know, the market is sliding again and the 1.3350 level comes back into focus. The whole process is repeated again. Often the positions acquired in these “defensive” operations are in the hundreds of millions of euros (or dollars, or AUD, etc, depending on the market). A few “round trips” and whether or not the option position is profitable becomes irrelevant. The defense makes huge profits all on its own, if successful.

What does the price action look like when option defense fails?

How often have you seen the market slip through a much-talked about level by a few pips only to turn around and rally strongly? Likely the culprit is an effort to trigger a barrier. If Bank A sold 500 mln EUR/USD to force the market lower and extinguish barrier options, it has to quickly turn around and cover that short, leading to whipsaw price action. It avoids the huge payout but could get hurt if it can’t cover its short profitably.

ForexLive is one of the few places where traders can pick up information of exotic options that are in play. We try and alert traders to these structures so they do not get caught selling what looks like a breakout only to see the market quickly reverse field.

Barrier options can also be added to plan vanilla options strategies to make them less expensive. For example, if you think EUR/USD is going straight up, you may be willing to buy a 1.45 euro call with a 1.3500 knockout. As long as EUR rallies through your strike price, you make money, but you will have paid a smaller premium because you assumed the risk that your option could be extinguished if prices fell below 1.3500 before expiry…

15 Comments

  1. Thank you Jamie!
    I love to learn the forex with you:)

  2. Where would one go with your $1m to buy a DNT, Jamie?

  3. Snidely Whiplash and Co would be happy to help you…or any other bank

  4. whats the minimum amount to buy such exotics from banks which offer them?

  5. Thank you Jamie,this is most interesting….there is any possibility for a small retailer player to have access to this kind of options strategies? I mean,there are brokers who offer this FX options or there are only banks for big players? If they are ,could you recommend some? And some educational sites? I don’t write very much here,my financial English is not so fluent ,but I want to express my deeply appreciation for what are you doing here at forexlive :) Thank you very much again

  6. Thank you for a great study lesson Jamie! :)

    Andy

  7. I believe there may be some firms that offer exotic options to retail but I am not familiar with any of them…I’d try Google and do some research from there…

  8. Awesome article.

  9. What is a $100 million of pay-out worth in a $4 trillion dollar a day market? Would the risk they have to take influence the market be to high, to only get a $100 million.

  10. Thank you Jamie, one of the best posts I’ve ever read on any informative site. The option world seems to be the best kept and hard to educate secret for traders.

  11. Amazing info here Jamie and co. Thanks.

  12. Great info, Jamie. I’ve been doing a lot of studying on trading around the DNT option levels for a few months, but I even learned a few more things here. Specifically, “A few ’round trips’ and whether or not the option position is profitable becomes irrelevant. The defense makes huge profits all on its own, if successful.” I hadn’t thought about that before.

    My only other comment, are you sure you have the figures correct on the 1.3350/1.3850 DNT option that the Chinese are currently sitting on? Maybe you meat to say 1.3350/1.4850 or something else, because right now (and at the time of your post yesterday) EUR/USD is outside of that range.

    Nonetheless, great work and thank you for the post!

  13. Sorry, took that off the shelf, was written at a prior time…

  14. Thanks for re-posting this Jamie. DNTs (and options in general) are great ways for finding liquidity. As a retail trader, fading the move seems safer than going with the hunt.

  15. Is there anyway to find out what DNT’s are in play at any given time?

Top

© Copyright 2014 ForexLive™  |  Advertise With Us  |  Login To Comment  |  Sitemap

HIGH RISK WARNING: Foreign exchange trading carries a high level of risk that may not be suitable for all investors. Leverage creates additional risk and loss exposure. Before you decide to trade foreign exchange, carefully consider your investment objectives, experience level, and risk tolerance. You could lose some or all of your initial investment; do not invest money that you cannot afford to lose. Educate yourself on the risks associated with foreign exchange trading, and seek advice from an independent financial or tax advisor if you have any questions.

ADVISORY WARNING: FOREXLIVE™ provides references and links to selected blogs and other sources of economic and market information as an educational service to its clients and prospects and does not endorse the opinions or recommendations of the blogs or other sources of information. Clients and prospects are advised to carefully consider the opinions and analysis offered in the blogs or other information sources in the context of the client or prospect's individual analysis and decision making. None of the blogs or other sources of information is to be considered as constituting a track record. Past performance is no guarantee of future results and FOREXLIVE™ specifically advises clients and prospects to carefully review all claims and representations made by advisors, bloggers, money managers and system vendors before investing any funds or opening an account with any Forex dealer. Any news, opinions, research, data, or other information contained within this website is provided as general market commentary and does not constitute investment or trading advice. FOREXLIVE™ expressly disclaims any liability for any lost principal or profits without limitation which may arise directly or indirectly from the use of or reliance on such information. As with all such advisory services, past results are never a guarantee of future results.