Spreads and Exotic Options

If you are long the base currency, hedging with a protective at-the-money put option is a great strategy. But it's also an expensive one because it protects against all downside risk exposure. And currencies typically won't depreciate to zero over the time period of the put. In fact, most currencies never depreciate to zero. So a portion of your put premium is protecting against a very low-risk event. Fortunately, you can reduce the cost of that protective put by taking back some of the low-risk risk. How would you go about structuring this?

You got it! If you sold an out-of-the-money put option, you could reduce the cost of the ATM put and also accept some of the downside risk. It's called a __put spread__, which is basically buying a higher strike put option and writing another lower strike put option to help cover the long put's cost. Usually, both put options have the same expiration. Clearly, this strategy is best when the base currency depreciation is assumed to be minimal, and it requires consistent monitoring for any adverse exchange rate movements.

No. That's not going to accept additional downside risk, and it's going to cut into potential appreciation.

No. Buying a call option will increase the cost of the overall hedge.

It's also important to structure the put spread to have the best risk–reward ratio. Since the put spread isn't a zero-cost strategy, you can alter the cost structure by changing the strike prices, using different notional amounts, or some combination of these two approaches. Again, there are risks and rewards with each alternation. For example, if you chose to move the put strikes closer together, it changes how much downside protection you have. So what happens to the downside risk?

Right you are! If you move the strikes closer together, you'll accept more downside risk because the out-of-the-money put you sold would move closer to the at-the-money put. Instead, in order to change the risk structure, you could write a larger notional value for the deeper out-of-the-money option. Many asset managers use this approach and adjust the notional value of the deeper out-of-the-money option that they sell to be twice the notional value of the at-the-money put on the base currency (that they buy). But you'll need to be especially careful, as the 1-2 exposure ratio acts as leverage. How does this change your exposures to the base currency?

That's not it. The range between put option strikes is lower, not higher.

Clearly, no. Altering the strikes will impact the downside risk.

No. The spot exchange rate is now lower than if it was hedged at the money.

That's right! Since the notional value has been doubled on the short put, it's giving you double the exposure to the base currency. That's why it's so important to manage the 1-2 exposure. Many times, asset managers will pay to exit the position prior to the exchange rate hitting the out-of-the-money strike. But since that can be extremely expensive, many managers only use 1-2 notional exposures for directional trading.

Not quite. The base currency exposure was hedged, and then the notional value of the out-of-the-money put was changed.

Other managers will avoid the additional leverage and combine the put spread strategy with an additional covered call position. That's called a __short seagull spread__, where you buy an at-the-money put, sell a deep out-of-the-money put, and a sell an out-of-the-money call option. And since there are two options being written to gain premiums, you can adjust the strikes to find the optimal cost or exposure that you desire. But, again, a short seagull has multiple costs to the asset manager in exchange for lowering the premium costs. What's one of the costs that a short seagull spread creates?

Not so. The two short options reduce the hedging costs.

That's right! The short seagull lowers the upside potential through the sale of the call option. So the call option effectively caps the upside potential. For this reason, many managers will use a long seagull spread, where an at-the-money call is written and out-of-the-money put and call options are purchased. This provides the portfolio with cheaper downside protection and retains the upside exposure in case the base currency appreciates.

Not quite. There's still limited downside protection between the long put and short put.

For some highly sophisticated investors, even option spreads aren't specialized enough for the specific exposures that these traders demand. That's where exotic options come in. Exotic options are designed to customize risk exposures and provide them at the lowest possible price. But just like other options, they will require lower downside protection or lower upside potential in order to provide specific risk exposures. For example, one type of exotic option is a digital or binary option, which pays a fixed amount if it hits its exercise level at any time before expiry. Given this unique structure, digital options offer high potential payouts for movements in the spot rate, almost like a lottery ticket. So what do you think the price of digital options is compared to vanilla options?

No. The additional leverage of a digital option makes it more like a lottery ticket.

You got it! Digital options have significant leverage to movements in the spot exchange rate because the option will pay off at any time if a certain level is reached. So that leads the price of the option to be higher than a regular, vanilla option because that payoff will be so large. There are also __knock-in__ and __knock-out options__, which describe when the option is initiated or created. A knock-in option is created only when the spot exchange rate touches a certain level, while a knock-out option is canceled when the spot exchange rate touches some barrier level. Since these options only apply under certain conditions, they're cheaper than regular options but provide less upside and downside protection.

No. The structure makes digital options have more leverage, which influences the price.

To sum it up: [[summary]]

Sell a put option

Sell a call option

Buy a call option

It increases

It decreases

It's not impacted

The spot exchange rate is now improved

The exposure to the base currency is doubled

The exposure to the price currency is doubled

Large premium outlay

Limited upside exposure

Limited downside exposure

Lower

Higher

The same

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