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Option Tips – Thursday, November 24, 2011
FXE Straddles and Hedged Plays



Option Tips for Trading the Huge Euro Move that is Coming!

Euro’s Bizarre Strength Won’t Last: Barclays

Potential Euro Trust (FXE) Trade Has 2.53% Downside Protection



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Euro

The Euro set an all time high against the dollar in the spring and early summer of 2008. That was around 1.60 versus the dollar, meaning that €1 could buy $1.60, and we could easily eclipse that level in the next two months.

On the other hand, the more popular belief is that the Euro will crumble, falling below the 2010 low of around 1.20 versus the dollar on its way to parity. These two insights sets the scene for the option tips.

While the euro has been surprisingly strong lately, it is set to come under more pressure, says Barclays Capital.

The euro has held up well in recent weeks despite the continued turmoil in the euro zone, in part because of liquidity being provided by central banks and the expected repatriation of foreign assets by European banks back into Euros, according to Barclays.

That said, Barclays expects such support to “lessen and the euro to come under renewed pressure” in the days ahead.

It’s down 1.2% today against the dollar at $1.3354. That’s still higher than its recent intraday low of $1.31, set back in September.

And the euro is still slightly higher for the year.

The option tips can allow you to profit from either of those outcomes, but before we get to the strategy let’s take a look at both the bearish and bullish cases.

The Bear’s Argument to Support the Option Tips

The bear argument is the most popular. Due to the sovereign debt crisis on the continent and the ripple effects on European Banks, it is widely believed that the European Central Bank (ECB) will need to print its way out of this mess.

euros

If the ECB takes this route, it will need to print billions -- if not trillions -- of Euros. By creating new currency, the value of the existing currency in circulation will be devalued, leading to inflation.

As a simple example, if all the goods and services in Europe could be purchased for €1000, and the ECB adds another €1000 to the mix, since there are no new goods and services, all the existing ones now require €2000 to be purchased. The doubling of available currency does not change the real value of goods and services; it simply decreases the purchasing power of a single Euro.

This is bad news for people who have to buy things or people who have lent money, but it’s great news for people who owe money. If you owe someone €10.00 and the money supply suddenly doubled, it wouldn’t change the amount you owe but it would reduce the relative value of your debt by roughly half. The process of reducing debt burdens through printing money -- or quantitative easing, as it is known today -- is also supposed to be a stimulative action for the economy by making European goods cheaper to the rest of the world.

Thus, in one fell swoop, the ECB can reduce the real value of sovereign debt burdens of the peripheral nations and stimulate their flagging economies. It can be well argued that quantitative easing is not effective based on two rounds of QE orchestrated by the Federal Reserve here in the States. Of course, since we don’t have a parallel universe in which to observe what might have happened if we didn’t have quantitative easing, it’s very difficult to prove or disprove its value.

One thing to note, however, is that in the process of creating more money, the Federal Reserve did devalue the dollar. In the weekly chart of the dollar index below, the approximate time frames of the QE programs are highlighted in yellow. Although the trajectory isn’t straight down, over the course of nearly 2 years, from where QE1 was initiated until the conclusion of QE2 in June of this year, the dollar sank approximately 17% against a basket of currencies.

usd



So the bearish case is reliant on the ECB revving up the printing presses and potentially sending the Euro down by 15 to 20%.

FXE-112311-options



Looking at the option action over the past two weeks, many option traders are certainly very bearish in their approach and believe that this is definitely the direction that the Euro will be going – certainly helping support the option tips!

However, Germany, which for all intents and purposes is running Europe, is staunchly opposed to these types of measures. Thus, the alternative outcome and the bullish case present another perspective to the option tips.

The Bull’s Argument to Support these Option Tips

If you can’t print money, then how can this situation be resolved?

Until recently, it was considered taboo to even contemplate the ejection of member countries from the monetary union. Remember: there’s a difference between the European Union (which includes 27 countries) and the European Monetary Union (which includes 17 of the EU countries and uses the Euro as their common currency). Now they’re at least talking about ejection.

Candidates for removal from the monetary union include the usual suspects: Portugal, Italy, Ireland, Greece, and Spain (PIIGS). Ejecting any or all of these peripheral nations would leave a much more fiscally sound core. As a result, the Euro can gain considerably against the dollar, perhaps as much as 10 to 15%.

There’s always the possibility that some of the PIIGS nations will sacrifice some of their sovereignty for greater fiscal union within the monetary union. In other words, in order to remain within the Euro, these countries will allow a supranational authority to make or guide fiscal decisions on spending and taxation. This would require modifications to the Maastricht and Lisbon treaties that established the European Union and its economic foundations. This is the angle that German Chancellor Angela Merkel is pushing and would further serve the option tips.

Both Greece and Italy have new governments as of last weekend, and Spain had elections yesterday. All now have conservative or technocratic governments that are likely going to want to toe the line and remain in the Euro. Unfortunately, these new governments may not be entirely representative of the people’s wishes and enforcement of new austerity measures and taxation may prove a challenge. Nonetheless, greater austerity or fiscal union is also likely to be a short term positive for the Euro, as perception spreads that recovery from the abyss may be possible.

The Strategies for the Option Tips

It is quite impossible to know whether the bulls or the bears will win the day. However, over the next two months, some clarity is going to be had with regard to an end point. Whether through conscious decision and agreements, or through an unexpected collapse of European unity, the Euro is likely to move considerably from its current value by the January 20, 2012 expiration of January options.

There are a number of key events that will occur between now and early January which will impact the option tips:-

• The European Commission will be actively discussing modifications to the Maastricht and Lisbon treaties.

• Greece’s new Prime Minister, Lucas Papandemos, will be working hard to convince his government to push through measures that will enable them to remain in the Euro. If Papandemos is successful, Greece will likely get its next bailout tranche, enabling it to roll €6.7 billion in debt this December. Failure is another matter.

• Mario Monti, Italy’s new technocratic leader, will also be busy convincing the world that he salvage the country’s debt situation and economic growth problems.

• Italy, Spain, and Portugal will all be issuing debt during December. Portugal is already well above the key 7% threshold for longer dated debt. Italy was back and forth around the 7% level over the last week, but the trend is not positive. Spain also has seen rates soar, with the trajectory toward 7%.

Each of these events will impact the ultimate decision on the “final” solution. Will the ECB engage in quantitative easing, sending the Euro into a tailspin? Will treaty modifications allow a greater fiscal union? Or will the PIIGS, all or in part, receive an eviction notice, strengthening the currency? Nearly any outcome could easily impact the value of the Euro by 10 to 20%.

The Option Tips

The first of the option tips where you can profit from a large potential move to the up or down side, which option traders use frequently is a strategy called the straddle. Most readers know that owning a call option allows its owner to profit from an upside move, whereas put owners benefit from downside moves. A straddle involves the purchase of both a call and a put. You can do this in the Euro ETF (FXE).

FXE logo

FXE is the Euro ETF. It's an exchange-traded fund by Rydex that tracks the Euro against other major currencies. Type FXE into your favorite stock quote system and you will see the current (or last) market price at which shares of this fund were traded on the exchange.

FXE was introduced in 2005. While each share has a net asset value (NAV) which represents the worth of the securities owned by the fund, the shares trade on the New York Stock Exchange just like stocks: when there are more buyers, the price is bid up. Conversely, when the price moves down it is because there are more sellers.

Options are available - you can buy and sell both put and call options on the FXE. Assuming you use a margin account, you can muster some substantial investment leverage with these options contracts. Keep in mind that leverage works both ways; if the market moves against you, the leverage can quickly wipe out your position or create a call for more funds.

The at-the-money strike is most often used to establish a straddle position. The at-the-money strike is the strike closest to the current price of the underlying stock. Since the expectation is for a considerable move sometime during the month of December and the early part of January, we can use the January expiration cycle with the option tips.

FXE-112311-chart



The Euro Trust (AMEX: FXE) closed Wednesday's trading session at $132.87. In the past year, the ETF has hit a 52-week low of $128.42 and 52-week high of $148.81. Euro Trust (FXE) has been showing support around $133.43 and resistance in the $135.23 range. Technical indicators for the ETF are Bearish.

The Example of the Option Tips

Prices have changed this week, but as of Friday’s close last week, the FXE was 134.62, which is the basis for this summation, making the 135 strike the at-the-money strike. Near the close, you could have purchased the January 135 calls for $3.20 and the January 135 puts for $3.95. The total cost of the straddle is the sum of the price of the calls and the puts, or $7.15. (Make adjustments accordingly! – review the recent chart above.)

The breakeven graph shows the potential profit and loss from the position on January expiration based on the price of the FXE.

FXE strategy



As you can see, this can be an inexpensive strategy, but it requires a significant move in the underlying. If the FXE closes on January expiration exactly at 135, then the straddle incurs the maximum loss of the premium paid, $7.15 or $715 for each straddle purchased. Between 127.85 and 142.15, the break even points, losses are still incurred but they will be lessened. If the FXE goes out at 130, the long put will be worth $5.00 and the long call will be worth nothing. Netting the $7.15 cost of the straddle, the loss on the position is only $2.15. The same is true if the FXE finishes at 140 on January expiration. But this time the call is worth $5.00 and put is worthless.

Once you get beyond the break even points, the profit potential is unlimited on both the up and down sides. Since the expectation is for at least a 10% move prior to January’s expiration, a downside move to 121.5 would value the put at $13.50 and the call of course would be worth zero. Net of the cost of the straddle you would realize $6.35 in profit or an 89% return on your investment. If the Euro falls any further than that, your profits would increase dollar for dollar with a decline in the FXE.

If the FXE move to the upside by 10%, producing a closing value of 148.5, then the call would be worth $13.50 and the put would be worthless. Net of the cost of the straddle, you end up with the same 89% return on your investment. If the Euro rises further than 148.5, your profits increase dollar for dollar with the rise in the FXE.

This can be a very powerful strategy given the right conditions, allowing you to profit from extreme up or downside move. Given the large potential move of the Euro and the FXE over the coming two months as the situation develops, a straddle can provide an interesting risk/reward scenario, but it is definitely not for everyone. If nothing else, this will hopefully give you an idea of the incredible potential in trading options.

Alternative Option Tips

Here are two more option tips which may be more suitable for your portfolio arrangement.

1. For a hedged play on Euro Trust (FXE), look at the Jan '12 $134.00 covered call for a net debit in the $130.75 area. That is also the break-even price for this trade. This covered call has a duration of 64 days, provides 2.53% downside protection and an assigned return rate of 2.49% for an annualized return rate of 14.18% (for comparison purposes only).

2. A lower-cost hedged play for Euro Trust (FXE) would use a longer term call option in place of the covered call ETF purchase. To use this strategy look at going long the Euro Trust (FXE) Jan '13 $95.00 call and selling the Jan '12 $134.00 call for a total debit of $36.90. The trade has a lifespan of 64 days and would provide 1.68% downside protection and an assigned return rate of 5.69% for an annualized return rate of 32.46% (for comparison purposes only).


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