Protecting speculative trade management positions

Problem: A client has a profitable speculative FX forward position in euro/dollar and wishes to a) use a low-cost strategy to protect the profit of the existing long euro/dollar forward position and b) establish a new bullish position using options to address a more complex medium-term view.

Solution: In the first part of the problem, the client wishes to lock in some profit on an existing long-euro short-dollar cash position while retaining some upside potential. The strategy must match the tenor of the existing FX forward trade – so a one-month horizon – and be tailored to the client view: 'euro/dollar trades below 1.25 for the next two weeks until the key US data is released and then grinds higher towards 1.28'. The strategy must also have an acceptable worst-case protection, for net zero premium upfront.

A strategy commonly used to lock in profit while retaining some upside is the kick-into forward (KIF). In this scenario, the regular KIF would be constructed from a long plain vanilla euro put and a short kick-in (KI) euro call, both with the same strike at slightly worse than the market FX forward rate (to keep the strategy zero premium). The client has locked in the profit with the euro put and can benefit if the currency strengthens up to the KI barrier on the euro call. If the barrier is crossed – the euro put becomes a synthetic FX forward (courtesy of the euro call, which kicks in).

One particular type of exotic barrier option – the moving barrier option – allows the user to specify different barrier levels for different periods during the life of a single forex option. Replacing the regular KI euro call with a moving barrier KI euro call allows the strategy to be fine-tuned to the client's view on euro/dollar spot. The following is the comparison between a one month regular KIF and the moving barrier KIF (spot ref: 1.2250):

Regular KI forward 1.2105 1.2800

Moving barrier KI forward 1.2140 1.25 for the next two weeks, 1.28 for the remainder

In the case of the regular KIF, the euro put option kicks into a 1.2105 FX forward to sell euro if spot trades up through 1.2800 prior to expiry. With the moving barrier KIF, the euro put option kicks into a 1.2140 FX forward to sell euro upon euro/dollar trading up through 1.2500 in the first two weeks, or 1.2800 in the remaining time until expiry.

Using a moving barrier KIF, the client picks up an additional 35 dollar pips on the take-profit rate vs the regular KIF, in return for having the barrier positioned three big figures lower for the first two weeks.

In the second part of the problem, the client wishes to establish a new long euro/dollar directional position but with a specific view in mind for the next three months: euro/dollar spot will move higher but is unlikely to breach the all-time high in euro/dollar (1.2925). However, if it does, spot is likely to retrace by one or two big figures.

This view can be expressed using an appearing barrier option (ABO): purchase a three-month 1.2250 (at-the-money-spot) euro call with a 1.30 barrier. If spot touches the barrier at any time, the option becomes a long 1.3000 euro put with a kick-out (KO) at 1.2500 with the same expiry date as the original euro call option. The ABO costs 0.68% euros. Compare the value of this option versus:

Plain vanilla 1.2250 (ATMS) euro call 1.91% euro

1.2250 (ATMS) euro call with RKO 1.30 0.60% euro

The ABO strategy costs only 0.08% euro more than the RKO, yet provides the flexibility of automatically re-positioning for a retracement if euro/dollar trades at or above 1.30 during the life of the option.