Euro Calendar Spread

On September 19th, EUR/USD futures for December expiration touched the highest levels since February as the dollar plunged following the Fed decision to delay a reduction in asset purchases. Since then, the euro has backed off slightly, but record low levels of option implied volatility provide an excellent way for traders to position themselves for the next move.

ECZ13 Futures

Source: TradeStation

Let's review the volatility environment in the euro to determine the optimal structure.

EUR/USD 3M Implied Volatility.

Source: Condor Options

First, at about 8.5% annualized, EUR/USD three month at the money option prices are near their lows for the year. That means investors with natural exposure to a falling euro can buy protection here at levels not available in many months; speculators can position for a drop in the currency in a more cost-effective way.

EUR/USD 3M/1Y Term Structure Slope

Source: Condor Options

Second, the term structure of option premiums is also near an extreme level: relative to the cost of one year options, three month option premiums are near their lows for the year. Put differently: excluding some recent lows in mid-September and a handful of dates in the spring, the contango in the term structure of options on the euro hasn't been this steep since 2013 began. What the attached chart should make clear, though, is that while EUR option volatility can trade in a stable way for long stretches, it is also prone to spikes higher, with short term options being bid up sharply versus longer-dated contracts: the term structure has backwardated several times in 2013 alone.

The following calendar spread has a similar payoff to a long straddle, with one important difference: if stress in European banks or sovereigns flares up in the coming months, or if the dollar strengthens against the euro as a result of reactions to monetary policy changes, traders can expect the IV term structure to flatten, which would benefit a short calendar spread to a greater degree than it would a straddle (in risk-adjusted terms).

Trade: Buy to open the 6EZ3 December 1.345 puts for $0.017 and sell to open the 6EH4 March 1.345 puts for $0.0262.

The position risks about $1350 per spread at December expiration if the futures are near the strike of the options, versus an expected return of about $550 on a one standard deviation move in either direction. We will update this position on any sizable moves in the underlying and will plan on exiting in mid-November.

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