FxWirePro: Luring Lonnie’s optionality - USD/CAD unlikely to hit 1.23 knocks out from above 1.32

Even the sharp renewed decline in the broad dollar is well explained by the fact that the US largely sat out of the rates repricing phenomenon that took hold of large parts of the rest of the G10 universe. The end result is a substantial reorganization of the policy normalization pecking order where the USD has gone from the front of the pack in terms of priced hikes by end-2018, to the middle, and CAD has lept to the top of the heap with more than 50bp hikes priced.

The loonie keeps flying on rate hike hopes: Watch out for below 1.29 levels, the Bank of Canada’s rate hike is looming on the other corner, if not in the July meeting then in September, and this is now priced in. The BoC is giving greater prominence to financial stability concerns stemming from high Canadian household indebtedness and regional housing booms.

Buy USDCAD 2m put strike 1.27, knock-out 1.23 Indicative offer: 0.40% (vs 0.48% for the vanilla, spot ref: 1.2992)

Unlike a vanilla call or put, the RKO maximum potential leverage can be monetized only in holding them until the 2m expiry. These short gamma options are long theta so that the time value slowly converges towards the intrinsic value only in the end.

Risk profiling: Massive downside Investors buying a knock-out option cannot lose more than the premium initially invested. However, if the USDCAD hits the 1.23 barrier at any time before the 2m expiry, the option will instantly expire.

It seems that even though the early 2018 target for USDCAD has been reached, the loonie’s undervaluation should support further appreciation in the months ahead. According to our technical analyst, a daily close below 1.30 will confirm the next leg of the decline towards May 2016 lows of 1.25 with intermittent support at 1.2770.