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Foreign Exchange

Reset shorts on euro via options market, say analysts

This month’s EURUSD rally appears to be faltering as realization sets in that the eurozone’s grand plan is not likely to be implemented anytime soon and the fundamental economic outlook continues to look bleak in Europe.

Since October 3, EURUSD rallied from 1.3275 to 1.39148 on October 14, as markets took some relief from European leaders’ efforts to resolve the sovereign debt crisis. But from Monday, after German finance minister Wolfgang Schäuble warned investors not to expect a comprehensive solution from this weekend’s EU summit, there was an early euro sell-off.  The issues with enlarging the EFSF also seems to be getting more contentious by the day. Reports indicate that there is significant divergance of opinion between France, Germany and the European central bank regarding the role of the ECB to leverage the bailout facility.

EURUSD is now trading around 1.3729 on Thursday morning in London.

This presents an ideal opportunity for traders to reset their euro shorts in light of the relief rally, whilst shielding themselves from key event risk over the coming weeks as more detail emerges from the eurozone proposal.

“The German finance minister’s comments, which have sinced been echoed by German Chancellor, Angela Merkel, are an early sign that investors should temper their expectations for a big announcement out of the EU summit this weekend,” says Andrew Cox, an FX strategist at Citigroup.

“They are also indicative of German opposition to some sort of rushed deal, of which they would likely shoulder a significant portion of the burden.”

Citi suggests taking advantage of future EURUSD downside, whilst avoiding the upside event risk in coming weeks by buying a six-month 1.34 EURUSD digital put option, with a knock-out at 1.4050 starting in two weeks. The option is priced at EUR140,000 per EUR1million with a spot reference of 1.3800.

“The inclusion of the knock-out at 1.4050 significantly reduces the cost compared with a conventional put, whilst also increasing the delta of the option, which is around 500% with current spot,” says Krasimir Nikolov, of FX structure at Citigroup.

For illustration, if spot falls to 1.36 in two week’s time, the option’s value goes up by 50%.

“For an extra cost of 2% versus the immediate knock-out barrier, the two-week window provides investors with insurance in the case of any short-term spikes in spot,” says Nikolov.

Last week’s relief rally was the result of widespread short covering after overly aggressive selling in September. Positioning now appears to be more balanced.

Morgan Stanley’s latest positioning tracker – which tracks positioning through IMM data, the bank’s own internal flow, Japanese data from the Tokyo Financial Exchange and proprietary sentiment indicators – shows positioning in EUR and USD has moved towards more neutral levels.


Morgan Stanley FX positioning tracker - G3 
 
 Source: Morgan Stanley

With the shift in market positioning in mind, EURUSD is vulnerable to the downside risks if European policymakers are unable to produce a credible plan this weekend, according to analysts at several major FX banks. The euro remains vulnerable to the headwinds that hinder policymakers in forging a true “shock and awe” campaign to solve the eurozone’s debt crisis. Furthermore, any plans that lay down a comprehensive plan to tackle the deep-set problems in the eurozone will undoubtedly be subject to significant implementation risks.

“There’s a very big risk of a false dawn,” says Sara Yates, strategist at Barclays Capital. “We are still bearish on the euro in the next three months due to the sheer scale of what needs to be achieved.”

That said, positioning for euro downside is not straightforward. The potential for short-term upside risk, following the weekend’s EU finance minister meeting on Saturday, and with the EU summit this Sunday, makes leveraged positioning in the spot market unattractive.

Furthermore, implied volatility in the options market is still above 14%, making conventional EURUSD puts expensive.

Even in the event of positive steps towards delivering a sufficiently large and credible solution to the eurozone’s debt crisis, the implementation difficulties, and the bleak outlook for Europe’s economy and an impending ECB rate cut, will continue to weigh on the currency.

Cox concludes: “We expect Europe’s economy to continue to deteriorate in the coming months and expect the ECB to find it necessary to cut its base rate in reaction to disappointing growth data.”

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