Options Trade: Profiting from the Euro Decline in 2011

2011 will be an interesting year. The currency markets will likely continue to experience volatility, especially in the Euro-zone. The individual bond markets on the periphery of Europe will provide a good place to capture the volatility associated with sovereign risk. There is little doubt that the slow pace of the European sovereign debt saga, will create multiple opportunities to trade volatile markets.

The likelihood of an E-Bond, backed by the 16 countries in the EU, edge slightly forwards this week. E-bonds in theory would replace sovereign bonds that are currently being issued to finance euro zone governments. the E-bonds would theoretically form a much larger, EU bond market that would provide liquidity on an aggregate level.

The E-bond concept is an excellent theory, but this concept is not new, and the pace at which the EC reacts to fiscal issues, makes one believe that this will not be accomplished in the near term.

The chart of the currency pair EUR/USD appears to be correlated (with a lag) to the yield differential between German Bunds 10-year Yield and the US-10 year Yield. During the past 15 years, when the rate differential oscillated between the zero and -40 basis point level, the currency pair fluctuated in-between 1.20 and 1.30, with a brief dip down to the .90 level, but the yield spread had already foretold a rally in the currency pair by then.

Connecting a trend-line from the low yield spread in August of 1999 to the low yield spread in April 2006, creates a slope of the trend line that generates support near -110 basis points. The last time this occurred, the EUR/USD was below par.

The current economic situation supports a yield spread differential that is negative. At the same time the US economy is starting to pick up some speed, the European markets are mired in a fiscal disaster. The jobless numbers, in the US, will take some time to pick up, but employment is usually a lagging indicators, and jobless claims, have a trajectory that is moving toward better employment reports.

The yield differential will have ebbs and flows, given the disparity of issues that the EMU is facing. Slower economic growth is offset with concerns about debt payments. If the 10-year yields on the country level continue to widen, the pressure on the currency might become heavy.

The charts of European yield, display opportunities of higher relative peripheral yields, and a tighter European vs. US yields. In this scenario, the EUR/USD is likely to be lower.

The break out of the US 10-year note on a yield basis, could prove to the impetuous to push the dollar to higher levels. A yield above 4%, will be the buzz in the capital markets during 2011.

The 129 Put in the FXE (Euro Currency Shares Trust) is one way for an options trader to take risk on the Euro moving lower against the dollar. The implied volatility on the option is 14.95, which is the middle of the 19-9.50 range.

A direct short of the currency using a Forex broker would also generate a similar position.

The 1.20 level is a target for taking profit.

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Disclosure: No positions.

David Becker writes for Option Strategies Guide.