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FX Barrier Options

  • #1
  • First Post: Jul 8, 2012 2:30pm Jul 8, 2012 2:30pm
Hi,

I searched on Google, but was shocked how little info I could get from there.

I read in a forum that large players in the market look at Barrier Options that are near the spot price.

So, there are knock-out and knock-in options, example:

Knock out - if price gets to 1.20, option worthless
Knock in - if price gets to 1.20, option gets activated

My question is, how does that impact spot price? For knock-outs, option writers want to push price to 1.20, but the buyer of the option wants to defend the level.

But what happens if price gets to 1.20 - I mean what is the transaction in the spot market? Let's assume the volume of the option is 1 billion - does that mean when price hits 1.20 and the option is worthless, it triggers a 1 billion SELL trade?

Also, kind of difficult to read on IFR whether the barrier in question is knock in or out.

Thanks!
  • #2
  • Edited 11:31pm Jul 8, 2012 11:06pm | Edited 11:31pm
For the purpose of this discussion (and for simplicity's sake), I'm gonna assume we're talking about the following:

1. Spot EURUSD is now circa 1.2200.

2. There was a Eur call (i.e. USD put) transacted some time in the past, expiring say in 1 mths time, with a strike of 1.2100 but with an embedded knock-out at 1.20. The face value of the open EUR call option is say, EUR 1 billion.

3. (this means, currently the EUR call is "In The Money" but if spot touches 1.2000 between that time in the past when the barrier option was transacted and the expiration date, the option is rendered worthless)

4. (I'm gonna also assume we're talking about the more common-place "European" strikes, not "American" strikes. If you're not familiar with these terms, you should look it up.)

Note that, at current spot prices, I don't expect volatility to be high vis-a-vis that particular barrier option. Note also that there are OTHER barrier options in play in the wild, not just THAT one.

Usually volatility (if there is at all) will increase as spot APPROACHES the knock out level, not when the level actually touches. Why? There is a process called "delta-hedging" that options traders have to do (among other things) to hedge their open "option greek" risks.

Therefore, simply put, when the barrier level touches, the option is "dead" i.e. there is nothing left to hedge. If the option is dead before expiry, there is no option exercise of EUR 1 billion either (buy or even sell), but whoever hedged wrongly (either the option writer or buyer) could have lost a lot money from their hedging exercises prior.

Repeat: volatility is (usually) only up to the point when the barrier knocks out. Thereafter, it's back to business. THERE ARE OTHER LIVE BARRIERS IN PLAY in the background.

For a more detailed description, recommend you read Nassim Taleb's "Dynamic Hedging" (which is NOT for the faint-hearted)

Talking about FX options and their risks is very tiring for me unfortunately. Trading them is even more stressful. Maybe that's why I quit trading them...
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #3
  • Jul 8, 2012 11:28pm Jul 8, 2012 11:28pm
Btw, this is my opinion as a former insider:

Barrier protection is just an excuse to explain away volatility during quiet illiquid periods in the markets. Stops from retail traders will unfortunately be victims. Such things cannot be helped. If some retail traders cannot accept that the markets are much bigger than them, they will find the markets an unforgiving place.

My advice:
Take any such advance information (like current barrier protection levels) with a pinch of salt and not to be trusted completely. One may never know the SIZE of the position being defended, and one should not lose any sleep over the not knowing.

As for the difficulty of not knowing the context of the IFR news reports, it doesn't really matter if the report is talking about knock-ins or knock-outs.

What matters, in this case, is that there are bidders wanting to keep EURUSD well supported above 1.2000, and there are sellers wanting to breach that support and trigger other people's stops.

That's all you ever really need to know, really.

My two cents.
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #4
  • Jul 9, 2012 1:58am Jul 9, 2012 1:58am
Thanks so much for your explaination, skenobi!
  • #5
  • Jul 9, 2012 2:56am Jul 9, 2012 2:56am
That explanation is about as simple as I can make it to an outsider. I just hope it helps underline the complexity. (altho' in actual fact, it's a heck of a lot more complex than you think.)

Quoting Forex5050
Thanks so much for your explaination, skenobi!
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #6
  • Jul 9, 2012 10:01pm Jul 9, 2012 10:01pm
Quoting Forex5050
Hi,

I searched on Google, but was shocked how little info I could get from there.

I read in a forum that large players in the market look at Barrier Options that are near the spot price.

So, there are knock-out and knock-in options, example:

Knock out - if price gets to 1.20, option worthless
Knock in - if price gets to 1.20, option gets activated

My question is, how does that impact spot price? For knock-outs, option writers want to push price to 1.20, but the buyer of the option wants to defend the level.

But what happens if price gets to...
Good scenario. I'll explain with pics of what something like this could look like. A large trader purchases one yard ($1 Billion) NT (No-touch) option on Aud/Usd at 1.0300. He has so much ammo (sell orders) to defend this area if price shoots up to it.

What a successful barrier defense can look like. Red vertical line is when it expires.
http://i45.tinypic.com/oa7xwg.jpg

What a failed barrier defense can look like. Red line is expire. Notice the large trader's stop losses from the defense are just on the other side of the barrier.
http://i48.tinypic.com/2llkmea.jpg

Such large stop loss orders can move the market temporarily away from value. In this case it moves Aud/Usd higher when there was no reason for it to jump so high other than the battle that was going on.


Charts are examples of what it could look like and how these things effect the market. ESPECIALLY in times of low liquidity. I don't know if there was an option at that level (can't rememeber), chart is just to illustrate what it looks like.
  • #7
  • Jul 9, 2012 10:13pm Jul 9, 2012 10:13pm
Quoting Forex5050
My question is, how does that impact spot price? For knock-outs, option writers want to push price to 1.20, but the buyer of the option wants to defend the level.

But what happens if price gets to 1.20 - I mean what is the transaction in the spot market? Let's assume the volume of the option is 1 billion - does that mean when price hits 1.20 and the option is worthless, it triggers a 1 billion SELL trade?
Someone correct me if I'm wrong but I don't think the option tripping will effect the spot price, just the writer will win or lose. I think what will effect the market is the orders that are implimented from the defense or attacking of the option - and the outcome of it. Example of which is in the charts I posted.

Quoting Forex5050
Also, kind of difficult to read on IFR whether the barrier in question is knock in or out.
IFR should say 'DNT' (double no-touch) 'KO' or 'DIG'(digital) next to the options and sometimes the size of them. Options without such are plain vanilla set for NY or UK expiry.
  • #8
  • Jul 9, 2012 10:32pm Jul 9, 2012 10:32pm
You're not wrong. What will indeed affect markets are the hedging actions (in the spot market) of the option writers/buyers up to and until options knock out or expire.

At zero minute/hour/second (when options expire or knock out), it doesn't matter anymore. Even if options mature "In The Money" (ITM), the impact of a single (possibly large) exercise of an ITM option would have been absorbed by all the hedging that went before it. It may not be obvious to the man on the street, but unfortunately this concept can usually be grasped by reading books like "FX Options & Structured Products" by Wystup (for example)

Good stuff by the way!

Cheers!

Quoting EmeraldEyes
Someone correct me if I'm wrong but I don't think the option tripping will effect the spot price, just the writer will win or lose. I think what will effect the market is the orders that are implimented from the defense or attacking of the option - and the outcome of it. Example of which is in the charts I posted.
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #9
  • Jul 9, 2012 10:54pm Jul 9, 2012 10:54pm
Quoting skenobi
You're not wrong. What will indeed affect markets are the hedging actions (in the spot market) of the option writers/buyers up to and until options knock out or expire.
That's what I was looking for
  • #10
  • Oct 22, 2013 2:00am Oct 22, 2013 2:00am
Order activity due to an option barrier on Aud/Jpy @ 95.0
Attached Image (click to enlarge)
Click to Enlarge Name: audjpymm15.png Size: 49 KB
  • #11
  • Oct 22, 2013 2:45am Oct 22, 2013 2:45am
Quoting skenobi
Talking about FX options and their risks is very tiring for me unfortunately. Trading them is even more stressful. Maybe that's why I quit trading them...
skenobi, why do you think that options trading is stressful? The options provide various opportunities for trading and if you pick carefully you can almost eliminate the stress. I trade volatility and time rather than price. Today is a very good example.
Regrading the barriers, I couldn't understand why they are protected until hedging with exotic options structures as risk manager. I gained experience form "simple" Knock-In forwards (or risk-reversals) to TRFs with Knock In and some extra features. Actually, together with one of the banks we created a whole new structure. The problem with the barrier activation is that suddenly you incurr large loss. You know in advance that this could happen, but it is not pleasant. However, the large tradres in exotic options have the ammo to defend the parriers. Sometimes the payout only could be more than 20 mio. Unfortinataley the barriers are usually activated.
This is one of the successful DNT structures defense. The breakout above 1.51 is after the expiry. This DNT structure was purchased by an Asian sovereign and the payout was 20 mio (if I remember right).
Attached Image (click to enlarge)
Click to Enlarge Name: 32 EURUSDDaily DNT.jpg Size: 217 KB
  • #12
  • Oct 22, 2013 3:55am Oct 22, 2013 3:55am
Quoting srmfx
{quote} skenobi, why do you think that options trading is stressful? The options provide various opportunities for trading and if you pick carefully you can almost eliminate the stress. I trade volatility and time rather than price. Today is a very good example. Regrading the barriers, I couldn't understand why they are protected until hedging with exotic options structures as risk manager. I gained experience form "simple" Knock-In forwards (or risk-reversals) to TRFs with Knock In and some extra features. Actually, together with one of the banks...
When I traded options, I didn't "trade" them the way a retail trader would. I was "institutional" and usually that means I traded a whole portfolio of options and other derivatives with varying maturities, sizes, with all the accompanying greek risks (gamma, vega, theta etc etc) that come with them. I traded based on how more (or less) exposed I want to be on any of my AGGREGATE greek measures depending on my outlook of where spot will go and how volatile (or not) it will be, going forward. I didn't trade individual options or individual structures. I just sell them to (or buy them from) Bank sales dealers (who will pass them on to their clients), and I just add the new positions to my portfolio.

It's the management of the portfolio that's stressful.

Doubtless, trading individual structures is "less" stressful, but trading spot without all that derivative bullsh!t is more transparent, plus I don't have to lose to a Bank trader's nonsensical bid/offer spread when it comes to options.
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #13
  • Oct 22, 2013 4:31am Oct 22, 2013 4:31am
Quoting skenobi
{quote} When I traded options, I didn't "trade" them the way a retail trader would. I was "institutional" and usually that means I traded a whole portfolio of options and other derivatives with varying maturities, sizes, with all the accompanying greek risks (gamma, vega, theta etc etc) that come with them. I traded based on how more (or less) exposed I want to be on any of my AGGREGATE greek measures depending on my outlook of where spot will go and how volatile (or not) it will be, going forward. I didn't trade individual options or individual...
I see. I thought you were trading options as individual after you left the bank. As I risk manager I was working with banks' sales dealers and I can imagine what problems you had. The options are much profitable for the bank than the spot because most of the customers don't have the slightest idea what is the right pricing. Do you trade options now?
  • #14
  • Oct 22, 2013 4:35am Oct 22, 2013 4:35am
Quoting srmfx
{quote} I see. I thought you were trading options as individual after you left the bank. As I risk manager I was working with banks' sales dealers and I can imagine what problems you had. The options are much profitable for the bank than the spot because most of the customers don't have the slightest idea what is the right pricing. Do you trade options now?
After I left, I COULD trade options if I wanted to, but I didn't see why I should, because 1.) spot is more transparent, and 2.) I'm already making a lil bit of money trading spot on its own.

So, no, I don't trade options now.
I'm not trying to convince anyone. I'm not in the "convincing" business.
  • #15
  • Oct 22, 2013 6:05am Oct 22, 2013 6:05am
Quoting EmeraldEyes
Order activity due to an option barrier on Aud/Jpy @ 95.0 {image}
Buy stops above barrier at ~95.10 tripped, sending the AuD higher across the board.
Attached Image (click to enlarge)
Click to Enlarge Name: audjpymm15-2.png Size: 47 KB
  • #16
  • Oct 22, 2013 7:09am Oct 22, 2013 7:09am
Quoting EmeraldEyes
{quote} Buy stops above barrier at ~95.10 tripped, sending the AuD higher across the board. {image}
where do you get info like that on barriers and stops?
  • #17
  • Edited 7:42am Oct 22, 2013 7:22am | Edited 7:42am
Quoting usernamehere
{quote} where do you get info like that on barriers and stops?
News services that report info they recieve from dealers and large entities close to the market about the orders that are coming up. I found my order info sources by googling "order flow trading news" with social media these days, there's twitter feeds as well. Highlighted what I saw: http://tinypic.com/m/hsme4i/1

In this case, an option barrier, there is a side that is defending that level by selling as price approaches. Those defenders of the barrier place their stops on the other side, as that is when they will need to exit those shorts when/if the barrier breaks. That's how you can predict stops with these levels.
  • #18
  • Oct 22, 2013 7:27am Oct 22, 2013 7:27am
Quoting skenobi
For the purpose of this discussion (and for simplicity's sake), I'm gonna assume we're talking about the following: 1. Spot EURUSD is now circa 1.2200. 2. There was a Eur call (i.e. USD put) transacted some time in the past, expiring say in 1 mths time, with a strike of 1.2100 but with an embedded knock-out at 1.20. The face value of the open EUR call option is say, EUR 1 billion. 3. (this means, currently the EUR call is "In The Money" but if spot touches 1.2000 between that time in the past when the barrier option was transacted and the expiration...
Many thanks for taking time to inform us
So sorry for always replying late! But I got 2 Jobs!!
  • #19
  • Oct 22, 2013 11:40pm Oct 22, 2013 11:40pm
Barrier activated, buy stops hit, and plenty of liquidity for a good sell off.
Attached Image (click to enlarge)
Click to Enlarge Name: audusd...m1.png Size: 50 KB
  • #20
  • Oct 23, 2013 1:04am Oct 23, 2013 1:04am
Quoting srmfx
Barrier activated, buy stops hit, and plenty of liquidity for a good sell off. {image}
Yep, good example. I heard of barrier options on Aud/Usd every 50 pips from .9600 on up. Next one @ .9800.
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