FxWirePro: USD/TWD call KO spreads to capitalize on cheap skews and to participate in minor uptrend and major downtrend

USD appreciation following the Fed meeting was mainly due to the fact that the Fed did not change its own forecast, the so called dots (or did so only marginally). Every FOMC member gives their view of where the key rate should stand at a particular point in time (in this case in late 2018) independent of the other members. The public usually looks at the median.

While TWD implied vol is among the lowest in EM FX and close to the bottom of the 2yr range, while skew is also very low, making dollar calls relatively inexpensive.

Sensitivity of vol to spot moves is higher than other Asia pairs (except KRW), benefiting the structure if USDTWD moves up prior to expiration. Cheap skew improves attractiveness of the KO structure.

Buy 3m USDTWD call strike 30.70 knock-out 29.85 Indicative offer: 0.34% (vs 0.49% for the vanilla, spot ref: 30.19) Knock-out provides a 30% discount to the vanilla call option and also substitutes for a stop loss (distance to barrier 1% vs premium of 0.33%) on outright long USDTWD exposure.

Risk profiling (Rising equities and trend line support): The investors buying a knock-out call cannot lose more than the premium paid.

The option will expire worthless if USDTWD hits 29.85 at any time before the 3m expiry. Rising equities or a break of the cyclical low (29.92) could see a test of long term trend line support (29.70).