Using euro options to trade European uncertainty

With euro currency futures approaching their lows for the year, many traders are asking themselves if there is more downside to be had. With more dovish comments from ECB President Mario Draghi and a stalemate in Italian elections, the answer to that question appears to be yes.

Recently, Draghi announced that he expects inflation in the Eurozone to significantly miss the 2014 target of 2%. The slowing in Eurozone inflation is likely to continue a very accommodative monetary policy. The ECB has maintained that they are prepared to make large scale asset purchase on an unlimited scope if necessary.  However, should yields rise because of political turmoil, there may not be much the ECB can do. Italian yields did rise 50 bps in this week’s bond auction, and the ECB fears that a rise in yields could accelerate and possibly spread to Spain and the rest of the Eurozone.

With Italy in a stalemate, a run on their Treasuries could send the entire Eurozone back into crisis. The only way out of crisis for Italy is for a coalition government to be formed between parties with wildly different views. Even if such a government is formed, it is likely that they will call for new elections, increasing uncertainty over Italy’s fate.

Increased uncertainty surrounding Italy’s government, signs of slowing inflation and investors increasing anxieties around these issues, it is likely that the euro tests new lows. So if a trader has a bearish view of the euro what is the best strategy to use? A trader will want to use a strategy with a well-defined risk vs. reward setup.

Let’s examine some of the possible ways to take a bearish view of the Euro.

  1. Shorting spot EUR/USD. This is the most direct way to take a bearish view of the Euro, but can be capital intensive and would require a trader to take on a lot of risk when taking a medium- to long-term view.
  2. Short the ETF. The CurrencyShares Euro Trust (FXE) tracks the rice of the euro very well, but is the most capital intensive way to trade the euro. The risk required to take a long term trade is also high.
  3. Euro futures and options on futures. Provides leverage while still allowing a trader to set up a well-defined risk vs. reward setup.

Trade:
Buying the Apr 6E 1.28-1.275 Put Spread for $0.001
Risk: $125 per 1 lot
Reward: $500 per 1 lot
Breakeven: 1.279

The options market is implying that euro futures could move lower to around 1.27 by April expiration. This trade works well because it sets up for a risk vs. reward ratio that gives a trader 4-to-1 on his money with a much more conservative target than the options market implies.

 

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About the Author
James Ramelli

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.

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