FxWirePro: Intricacies of why to prioritize EUR/USD option structures over cash trades

Bullish EURUSD positions, ours included, were squeezed out by a trifecta of negative developments over the past week, specifically the upbeat Fed, the fractured outcome to the German elections (albeit this scarcely challenges perceptions of political stability in the core), and hopes that the Republicans can finally deliver a package of tax cuts. But having been stopped out from a cash position, we are inclined to reactivate a structural EUR long as speculative positions appear to have been meaningful trimmed, albeit this time through options to provide some insulation from what we acknowledge is a better tactical environment for the dollar.

Importantly, the Euro area recovery continues to fire on pretty much all cylinders and this continues to support 1) the prospect of a relatively progressive tapering of QE by the ECB, and 2) a continued re-weighting of longer-term EUR exposures.

Our medium-term target remains at 1.25 in EUR/USD and we establish a call spread on the low side of this with the approximate maximum leverage of 5:1. We are relatively relaxed that the euro can cope with additional Fed tightening (it has done pretty well to withstand two rate hikes already this year). Tax reform is potentially more of a wildcard, albeit this iteration of reform crucially lacks the prospect of border-adjustment which did so much to spur dollar appreciation when tax reform was first mooted early in the Trump presidency.

The US dollar has been crawling ahead in recent days, with the market-implied probability of a December Fed hike inching to around 80%. The FOMC minutes and US CPI data this week will be in focus. Fed Chair Yellen is also scheduled to speak on monetary policy this weekend, while ECB President Draghi will be part of a panel on “Rethinking Macro Policy” on the sidelines of the IMF-World Bank meetings.

The list of key market events this week includes:

Oct 11: FOMC minutes.

Oct 12: France CPI, EA industrial production, Sweden CPI, and US PPI.

Oct 13: Germany CPI, US CPI, US retail sales, and US UMich consumer sentiment survey.

The FOMC minutes, US CPI and Yellen speech may provide crucial signposts for the ongoing dollar rally. The positive carry on USD in the near-term may hamper spot EURUSD trades, given our view that the market continues to underprice the probability of a December Fed hike.

Hence, EURUSD spot trades are advocated to be squared off and activate options trades as stated below:

Buy a 2m 1.1650-1.21 EURUSD debit call spread (at spot reference: 1.1784).