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The Option Market Suggests the Smart Money is Getting Long the Euro

|Includes: CurrencyShares Euro Trust ETF (FXE)

While the press of popular opinion would have us believe that the Euro is going materially lower, the behaviour of the option market suggests that the Euro may well have already bottomed. Risk reversals have begun to diverge from the behaviour in the price of the Euro.

EURUSD 25 Delta 3 Month Risk Reversal (intraday)


EUR Spot (intraday)


 What is a risk reversal? Well in essence it is the difference in price of like for like (same strike and exp) calls and puts. Generally it is expressed as the difference between 25 delta (OTM) 3 months to expiry calls and puts (see here for a more detailed explanation).

Over the years we have generally found that “smart” or “informed” money tends to show up first in the options market which is why we tend to scrutinize the behaviour of risk reversals. Sure no system is fool proof but little things like risk reversals can give you that vital edge, which in the competitive world of currency trading, is vital.

But what about the behaviour of the CDS market for PIG nation’s debt? Yes the behaviour of the option market for the Euro and the bonds/CDS market for PIGs nations is diametrically opposed. On the one hand the CDS market is suggesting that a solution will not be found to Greece’s problems (and perhaps PIGs as a group), on the other hand the options market for the Euro is suggesting that either; it will be no big deal if Greece does default or that a deal will be acted on (as opposed to agreed) to save Greece from defaulting.

At the end of the day a trader has got to make a call, and that is exactly what we are doing, buying OTM calls on the Euro 3 months to exp. Within the next 3 months the Eurozone would have either blown apart (and if it does goodness knows how much the Euro will fall), or a solution will be found and acted upon, the Eurozone will be saved, and the Euro will be trading materially above 1.40. Why not buy puts as well? Because as the risk reversal suggests, calls are very cheap relative to puts, and given the record level of short selling in the Euro it won’t take much to cause a short covering rally propelling the Euro significantly higher. Furthermore, the level of short selling suggests that anyone who could get short the Euro (long USDs) has already done so........and making a habit of being long the world’s most crowded trades is the quickest way to the poor house! Of course we could be wrong in which case we will be limited to the cost of the short dated calls.....and we are certainly not betting the house on the resolve of the Germans to keep the Euro together!

Disclosure: Long Call Options on FXE