A Put On The Euro To Parity

| About: CurrencyShares Euro (FXE)

In a recent article on Seeking Alpha, we outlined a strategy to strangle the euro which is a bet on volatility, not direction. However, a growing number of analysts are becoming more bearish on the euro and overall European situation. With any meltdown in the eurozone, the best way to profit from a collapse of the euro is by buying a euro Put option (ideally spot EUR/USD (NYSEARCA:FXE)).

Why buying puts are better than other options strategies

When you purchase a put, you can set the amount, expiration date, and strike price. This will determine the cost of the put. However, you know how much you are paying for the put. It is difficult, if not impossible to calculate the amount of profit if it does go into the money, but you have theoretically limited risk with unlimited profit potential. Shorting EUR/USD calls would have profited during this same period, generating premiums. However the risk is in a EUR/USD reversal, the short covering of the position may wipe out any profit, or worse (it may create a big loss!).

Naked shorting options is simply more complex of a strategy, and definitely more risky. Shorting of options makes sense when you have the underlying, such as a long-term position in a stock that isn't moving much. Selling options can generate premiums while you wait. However, for this trade, we recommend buying puts because you know how much you are risking in the trade, with a potentially large upside.

Deep out of the money

The most propulsive puts are deep out of the money puts, in the case of the euro, a put at 1.20, 1.15, and 1.10 would be deep out of the money. The expiration date should be as far out as possible, as offered by your broker. Since these prices are so far out of the money, selecting an extended expiration date should not change the price much.

Sample trade from May

In the process of hedging portfolio creation on behalf of a European-based client, we have taken some demo options in order to monitor the behavior of the option in real-time while watching the EUR/USD spot price.

A long put was purchased at a strike of 1.20 EUR/USD 100,000 expiry August 1, 2012 when EUR/USD was 1.3230 (April 2012). As of (5/26/2012) it had a market value of $1,070 with a profit of $510, or 91% of the original price. That happened over a period of about 6 weeks. Not a bad return, but more importantly, you have a limited, controlled risk, which in this case is the purchase price of the option ($560).

Suggested trade to profit from euro demise

Deep out of the money long puts EUR/USD at varying strikes, 1.20, 1.15, 1.10, 1.05, 1.00 - for expiry as far out as possible. The amount taken should be considered carefully, according to your account size and risk profile. Do NOT invest more funds than you can afford to lose!

The risk of loss in trading foreign exchange markets (FOREX), also known as cash foreign currencies, or the FOREX markets, can be substantial.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.