SK: Surge in Euro Open Interest May Be Option Related
On Friday we had the expiration of the March options. As we have pointed out, the option trade has been very active in the euro, accounting for 15% or more of the total OI. There was a total reduction of 318,936 options at the Mercantile when March expired. Included were 77,172, euro calls and 106,629 puts. Remember that only the longs have the right to execute, or convert their positions to futures. Since the euro market has been on a bull run, the calls and not the puts are the options that have appreciated.
Traditionally, the option writers are the bookmakers and the buyers were and probably still are the bettors looking for action. Option writers are now more sophisticated, with complicated computer programs, providing guidance that allows you how to continue to write option premium and take advantage of time decay, and at the same time, stay delta neutral. Sounds simple right? From experience I know if you are short option premium in a volatile market with weeks until contract expiration, those will be very long nerve racking weeks.
Last week when the euro moved up toward the 1.40 handle, this was a boom to the euro bulls. In the euro futures the OI climbed from 218k to 252k on the last three days of the week. Option spec longs were likely converting their options to futures causing the OI to expand and leaving some option writer short. This mornings trade above the 1.40 handle may have been some profit taking and short covering. A reduction in the futures OI today would confirm this.
The long euro specs may be enamored with their positions, but there may be some storm clouds on the horizon. Spain, a problem country in the euro, where the one size fits all monetary policy as decreed from Germany and her allies, has major difficulties. There, the real estate bubble has broken, taking the countries 17 regional banks, also known as "cajas" down the oft traveled path to insolvency. These banks are now being forced raise capital, to comply with strict new banking regulations. It is estimated that these banks may need to raise 20B euros to meet the new requirements by the Thursday deadline.
While the peripheral countries suffer, burdened with their debt and austerity dictates mandated by the ECB, the Central Bankers are preparing to don their finest inflation fighting gear and raise the central bank rates. Perhaps the bankers and the creditors in Germany will congratulate themselves on their efforts to stem inflation, caused by higher food and energy costs, and beyond their control, but the debtor nations, already a miserable lot, will suffer even more.
The folly of this potential rate hike and the consequences on Spain and other countries was discussed by Ambrose Evans-Pritchard, in an article called "Flat-Earth European Central Bank misreads oil spike again, and kicks Spain in the teeth."
He says: "The West is not over-heating today, except perhaps Germany, and that may not last as China slows. The eurozone grew just 0.3pc in the fourth quarter of 2010. The UK contracted. The U.S. labour participation rate has continued falling over the last year to 64.2pc, the lowest since 1984.
Yes, China, India, and Brazil are overheating, pushing up global crude, metal, and grain prices. China alone is adding 850,000 bpd of oil demand each year, eating deep into global spare capacity. This is indeed a commodity demand story for the BRICs, but it has the characteristics of a supply shock for the West. There is nothing the ECB can usefully do about this, and it is suicidal to try. It is the task of the People's Bank to curb China’s credit bubble.
Trichet invoked the ECB's shibboleth of "second round” inflation effects. This is a sick joke as Spain and Portugal cut public wages by 5pc, Italy imposes a pay-freeze, and Ireland cuts the minimum wage by 11pc."
The hawkish euro talk about their noble fight against inflation has given us a run to the 1.40 handle. Perhaps as we get closer to that day when they indeed raise the rate we will get some more play from this story. Typically a market will run up in front of an announcement, and often fail after the rate hike. Currently the crowd is very long. I am not sure if it makes sense to fade them, but I certainly do not wish to join them.
