Too much of a good thing?

OTC currency option dealers are eagerly feeding on huge new flows, but say they risk choking on chunky trades. With bid/offer spreads too skinny to pay for liquidity risk, dealers have to make their money trading -- often against very tough customers.

It was the week the yen soared 6% in

a day, the Bundesbank cut its discount rate, and the U.S. bond market collapsed on bad news from the Philadelphia Fed. With the currency markets in turmoil, trading volume soared. On one day, Merrill Lynch doubled its typical daily volume in over-the-counter (OTC) currency options to $4 billion. A single speculator paid $5 million in premium for an out-of-the money, one-month option to buy $1 billion of a major currency, confirms Steve Geovanis, head of global currency trading at Merrill.

Though pleased by the deal, Geovanis was scarcely jumping up and down. Unthinkable just a few years ago, such trades are, if not routine, hardly surprising anymore.

The average daily volume of currency options hit $37.7 billion of which $31 billion was OTC) in April 1992, when the volume of all currency trading was $832 billion, according to a Bank for International Settlements (BIS) study released last year. The BIS's estimate of daily currency trading has since jumped to $1 trillion; options volume has grown proportionately much more.

"I'm bullish on the ratio of currency options to spot currency," declares William Johnson, global head of foreign exchange derivatives at Swiss Bank Corp., the market's largest player. "It's growing because the options can do everything cash can do, they're more flexible, and people's understanding of them has increased.

"One billion dollars in a major currency, in a stable market, at a liquid time of day, it's not a problem," he says. "On a spread basis -- one-month dollar/Deutsche mark 171 calls against 169 calls -- you could do several billion, and do it easily, without moving the price significantly."

But many players admit concern about the market's uneven liquidity.

"The market can swallow (the billion dollar trade) pretty easily if it's not followed by others," says Andrew Dexter, vice president in currency options at Bank of America (BoA) in New York. But sometimes one follows another, and the market chokes.

Often it's deliberate. The rapid growth in the market over the last three years was powered by big hedge funds and commodity trading advisors (CTAs) who embraced the high leverage of options -- and the defined risk and (relative) freedom from worrying about roll risk, small adverse market moves or margin calls that purchased options entail.

Big players often walk into the market, see it's short, and drive prices up against it.

"Some players want to move the market," says Bill Gilbert, head of global currency option trading in London for Chemical Bank. "That can move spot and bonds."

How it works Consider the French franc. Multibillion dollar sales of the dollar/French option last fall drove down implied volatility: Dealers overloaded with long positions lowered option prices to discourage new sellers (see "The perils of huge deals," below). The low implied volatility relative to dollar/D-mark options reflected supply and demand, not expectations of future spot volatility.

But the options ended up driving the underlying, as widespread delta-hedging of the dealers' long positions kept the franc abnormally quiet. Delta-hedging requires larger hedge ratios at lower prices, so dealers buy into price declines and sell into rallies; normally, such trading allows them to earn back the premium they paid. On such a large scale, however, delta-hedging limits spot volatility, which makes it unprofitable.

Low implied volatility then became a self-fulfilling prophecy, leading some dealers to joke the Banque de France must have ordered state-owned companies to sell options to stabilize the franc. In this case, such a central bank strategy would not have cost it a sou.

"Those that sold the options in late October did great," Dexter says. "The market makers were killed."

Such distortions in the market shouldn't occur. If dealers priced for liquidity risk -- quoting wider bid/offer spreads on bigger deals -- big trades wouldn't move the market.

But the need to see the trades -- plus competition from a host of new dealers -- has caused bid/offer spreads to contract to barely higher than is customary for spot. That doesn't make sense: Options are far riskier and more costly to hedge, especially the shorter-dated (one week to one month) options favored by those placing directional bets.

"People are falling over themselves to get the deal," Chemical's Gilbert says. "They are so gung-ho about getting into the market, they forget about the liquidity factor and whether the trade will move the market."

Robin Bauer agrees. A former trader at Chemical and PaineWebber who recently set up a CTA, Whitfield Capital Management, to trade currency options, she says, "Option risk is cheap. That's one reason the buy-side is the right side of the Street to be on. The market almost pays you to do your business."

As in spot, dealers are making markets for a pittance -- or a loss -- to see the flows. "We all make a judgment of who the valuable customers are. The hedge funds are valuable because they give market flow information," says the head of currency trading at a global bank. "That's a chance to make money -- or not to lose. If I'm blind, I'm vulnerable. The more information I have, the better a trader I can be."

While exchange traders grumble about the lack of transparency in the OTC markets, OTC traders suffer from it, too. Big trades can be like ocean liners at night that slip by unseen but leave other boats rocking in their wake. If a spec buys a $2 billion D-mark option or, worse, a DM1 billion option on the illiquid Belgian franc, from a single bank, it may take hours or days for whispers of the market-moving trade to spread.

Options traders then watch the waters for signs of the direction, size and kind of passing ships. Last year, when historical volatility in the D-mark was extremely low, occasional big jumps in implied volatility could be read as a sign of big orders by speculators hedging positions, says Philippe Baboulin, new head of currency option trading for Societe Generate in New York.

Logical explanation Conversely, sometimes implieds contracted or stayed flat when the dollar rose against the D-mark.

"It's illogical from the outside looking in," says BoA's Dexter. But from the inside, if you knew German exporters, expecting the Bundesbank to cut rates, were selling dollar/D-mark calls to hedge long dollar positions, the flat implieds made sense.

Insight into the rationale behind a market move can help a dealer design winning strategies. If you know selling pressure caused the dollar/D-mark implied volatility to remain flat despite a run-up in the dollar, you might buy the option.

"If spreads are cheap for the perceived liquidity risk, we want to be a customer, not a market maker," Chemical's Gilbert agrees.

Trading on the flows is not all defensive: Dealers routinely piggy-back customer trades, hoping to move the market with them. Simply being invited to bid for a trade lets a dealer know a trade is in the offing.

"If a bidder knows there's competition, and sees the market move, it will know the trade went through with someone else and trade in line with the customer," says a currency salesperson at Morgan Stanley. That is a danger to the bidder who won the deal, however.

But even seeing the trades often doesn't explain what's going on if a big hedge fund is involved. There may be other legs to the options trade, or bonds or equities involved. The options may merely leverage or hedge the core position, and the hedge fund may leg in and out of them. Seeing the flows in the spot and non-U.S. equity and bond markets can provide some clues; many times not enough.

Also, hedge funds and CTAs sometimes deliberately pick off dealers: In a strategy called "lining 'em up," a big spec will call four to eight banks for, say, $100 million of spot yen each without letting on it's doing multiple trades. When the banks all try to lay off their positions, they move the markets against themselves.

Sometimes, specs seem to do the same with options: Similar deals pour through the market at once. But Andrew Fately, head of global currency options at Lehman Brothers, disagrees. "More frequently, the specs are buddies. One will say 'I'm thinking of buying this option,' and three of them will do it at different firms."

In general, specs are more careful of burning options dealers because they need them more: Typically, they only have credit lines with a few that can deal in size.

Fately shrugs off other dealers' complaints. "The specs are the be best thing that happened to the market. They've added volume -- and these guys trade." Unlike corporate hedgers, who generally put on positions and leave them, he says, the specs "get in and out, and they like to get out with the guy they got in with."

Still, this can be frustrating. "If all of a sudden you see the one-month implied is higher, and you don't have an explanation, you bang down your phone," Fately says. "It's just part of the daily scream at the market. The market used to give you enough on the bid/ask. Now, you have to position correctly,"

Ways to position When bid/ask spreads are tight, dealers can't make money by just buying and selling matched positions, says Phil Vasan, head of currency derivatives at CS First Boston (dealers with the biggest flows, such as Swiss Bank and Citibank, may have sufficient economies of scale to profit on market making). Diversifying the source of flows creates some natural offsets, but dealers have to manage their books as a portfolio, spreading out risk over maturities and currencies, Vasan says.

Maturity spreads are pretty standard: selling one-month options to hedge two-month options. Spreading over currencies involves more analytics and risk. Recently, CS First Boston and others spread dollar/D-mark options against dollar/sterling options, betting sterling volatility will converge down to the D-mark's.

Just before the ERM breakup last fall, Merrill sold (relatively expensive) dollar/D-mark options to hedge purchases of (relatively cheap) dollar/French franc options. It hoped the spread would compensate for the risk and the close correlation in spot would hold.

Dealers also have to use their heads: "There are people I won't quote in spot because they try to make a living at the expense of Merrill shareholders," Geovanis says. "I have to weigh the value of the information against the risk."

That requires understanding the trading styles of different specs and what makes a dangerous trade: If a known predator calls at 3 p.m. to ask for a big, two-sided quote on sterling, it makes sense to say no, or to widen the spread substantially.

Avoid making dangerous enemies, Fately adds, "If you are on the wrong side of the guy pulling the trigger, you're likely to get killed."

One thing that angers customers is bait-and-switch: Tempting them with one price, then changing it.

Becoming one of the spec's pals also helps. Dealers can widen the bid/offer after doing a big deal, without angering customers, if they explain why. "If we say we're sellers, too, most specs are happy for the information," Geovanis says.

Other information may be exchanged. "One customer we used to refuse to quote, we trade with now," Geovanis adds. "We agreed that when they're building a position, they won't put us at risk. They'll tell us they like the currency, ask us to help them build a position, and give us a chance to cover it." (The deal is off if the customer's in a losing position, Geovanis adds.)

Collaboration may be closer. Many dealers show customers a trading idea, planning to trade with them. "If we advise him to do the trade, we believe it. We don't just cover our position relative to him, we'll do more, go net in the same direction," Geovanis says. The customer might come back a week later, say the market hasn't moved, and say, "let's do more."

More often, customers already have a view; They just want help figuring out the most efficient options strategy, traders agree. The more customers undress and show the other legs to the trade, the better advice and more help they'll get driving the market the right way.

Blue moon

There was blood in the Street when the yen jumped to 101 per dollar from 107 on news of the collapse of U.S.-Japanese trade talks. George Soros' Quantum Fund, for one, reportedly lost 6% in two days. But what's pain for the goose is profit for the gander: When the spot price spike sent implied volatility on one-week yen options soaring from the typical 12% to 22% annualized volatility, some traders saw a nice opportunity to capture rich premiums by selling yen options.

Bank of America came up with this trade, which Julia Carter, vice president in FX option sales, calls the bank's most successful ever in terms of the number of clients that grabbed the idea and profited by it.

BoA advised selling knock-out options, an increasingly popular exotic that evaporates if the spot hits a specified trigger. Sellers exact lower premiums in return for the possibility the option -- and their risk -- may terminate early. The faster the option disappears, the happier the seller is.

When yen was at 102.5, some clients sold one-year dollar puts/yen calls obligating them to sell yen and buy dollars at 98 at expiration, but which would knock out if yen hit 104.5.

"To me, that trade had no risk," Carter says. "I don't care if yen goes to 85, at some point in the next year, it had to go back above 104.5."

In fact, yen hit the trigger level just two days after the option was sold, allowing happy sellers to pocket their 1.32% premiums and move on to the next trade. Says Carter: "It was a once in a blue moon trade."