Analysis: FX options market unconvinced of euro rally

NEW YORK (Reuters) - Expectations of more euro zone interest rate increases have enhanced prospects for the euro this year, but the options market isn't buying it.

Options investors are still betting on a decline in the euro against the dollar, with risk reversals for one-month options still showing a solid bias for "puts" despite an 8.3 percent surge in the single currency this year.

Analysts said there is a tug-of-war going on in the options market between market makers, who provide liquidity, and institutional buyers, who seem skeptical that the euro will keep on rising given persistent sovereign debt problems.

The euro's negative bias in the options market has been in place since October 2009.

A European Central Bank rate increase of 25 basis points to 1.25 percent last week has propelled the euro to 15-month highs versus the greenback. The currency is likely to hold gains as financial markets have factored in about 75 basis points in monetary tightening by the ECB.

Normally, as the euro rises, risk reversals tend to turn neutral and later start exhibiting "calls," or bets that it will rise. That has not happened yet.

"We're looking at euro/dollar crawl higher, but at the same time risk reversals have not narrowed to reflect the direction of spot," said Simon Smollett, senior currency options strategist at Credit Agricole in London.

This may suggest that the options market is not too eager to jump on the euro bandwagon.

Smollett said there may be a squeeze going on in the options market between market makers, disinterested in which direction the currency takes, and so-called directional traders -- the corporate hedgers and institutions.

Market makers are being forced to buy downside euro/dollar risk reversals to balance their portfolios, having sold sizable strikes at lower levels in the euro.

At the other end, corporate hedgers have no desire to grab upside euro/dollar strikes either.

"Market makers are refusing to narrow their prices, refusing to make them budge toward parity or in favor of euro calls. Until they actually see a large body of corporate and institutional interest to buy topside euro/dollar, risk reversals are not going to move to the upside," said Smollett.

Fundamentally, the euro is still facing huge sovereign risks. Portugal was the latest euro zone country to seek a bailout after Ireland and Greece. It may not be the last.

Analysts said rate increases by the ECB could hurt fiscally weak peripheral nations such as Spain through higher bank funding and mortgage costs for the broader economy.

A significant amount of mortgages in Spain track the official bank rate, so higher rates could raise the cost of debt service, analysts said. For the troubled Spanish savings banks, mortgage loans are their single most important exposure to the deteriorating housing market.

This may be one reason why options investors aren't more bullish on the euro.

"We think that the euro rally should remain vulnerable to potential further disappointments from Spanish government auctions," said Valentin Marinov, senior currency strategist at CitiFX in London.

POSITIONS RISE, FEAR OF AN EVENT RISK

Some in the market think the divergence between the skew in risk reversals and the spot market may also be caused by the buildup of positive bets on the euro in the futures markets.

Data from the Commodity Futures Trading Commission showed euro net long positions totaled more than 59,000 contracts in the latest week, a one-month high. See <IMM/FX>.

As the euro rises to extreme levels, however, the prospect of a pullback also increases, leading investors to hedge that risk.

"Because there are a lot of people long euros, they are looking for low out-of-the-money puts to protect their downside," said Ron Leven, executive director for currency research at Morgan Stanley in New York.

A put option is "out of the money" when the price of the underlying currency is greater than the strike price.

Leven said some investors could be hedging in anticipation of the risk in a huge event, something that could cause a major change in direction.

"When you have a sense of a big downside risk, then stops become a less effective way to protect yourself," said Leven. "The market may turn a long way from where your stop is and so your effective risk is much bigger. So there's a lot more demand to protect through options than just having a stop."

To be fair, euro/dollar risk reversals have come off extreme levels. In late November, the euro's "put" bias was at -2.73 vol. On Tuesday, euro risk reversals traded at -1.35.

But the negative skew has occurred at a time when implied volatility, a measure of a currency's movements in either direction, is low, suggesting a -1.35 vol skew from a high of -2.73 was no improvement at all, analysts said.

(Editing by Padraic Cassidy)