Currency Option Hedging Framework:
The rationale behind this strategy: From last one month it is observed that the Euro Canadian pair has been moving in 2nd channel line band width of 270-280 pips. As shown in the diagram it is quite important to note that if prices are trying to break this range then the very next day there would be adverse price reactions which would mean that the major tolerance level for price is around 270 pips.
If you think Euro to spike up against Canadian dollar, then cover your underlying currency exposures with collars strategy. This strategy is for those who have Euro exposure at present who are concerned about a correction and wish to hedge the long spot currency position.
The hedger takes following positions to construct this strategy:
Write an OTM call option + hold an ITM put option (near month Call & mid month put). This helps as a means to hedge a long position in the underlying outrights by holding longs on protective put. Thereby, any declines in this pair would be taken care by ITM put options since the holder of the put option will have right to sell at predetermined strike price at expiry in case of European style options.
Rollover advantages: While executing the collars it is important to select the ideal put and call combinations that consent to profit while still protecting the downside risk. Many investors will roll the puts and calls in the collar strategy each month and lock in a 3-5% monthly return. By rolling, you would buy back the short calls and sell new calls for a later month and perhaps different strike price, and do the same with the puts. Hence adjusting the collar based on the movement in the exchange rate.
Maximum return = Strike price of call - Currency spot price - net premium paid or Strike price of call - Currency spot price + net credit received on short side.
