Trading around the barriers: Forces at work in Spot market

This is an interesting bit on trading barrier options which has come out of my interaction with some option traders. The breadth of FX exotic products traded these days is considerable and one of the most commonly traded exotic option is a knock out option- this is a vanilla option but with an additional feature where it disappears if a given in the money barrier is crossed at any point during the life of the option. This is popular because this feature reduces the price of this option.

Consider a very realistic situation where a market maker would be selling this KO call option to an investor which results in a short position for the market maker. The delta hedging requirement for such an option would vary across spot and time. The market maker has a gamma position similar to a vanilla option near to strike which makes him short on gamma and hence needs to buy spot as it rises.

The interesting thing is that as the spot approaches barrier, the curvature reverses and the trader gets long gamma as a result of being long the barrier and short on the call. As the delta exposure becomes increasingly positive, the trader hedges this by selling large amounts of spot as it approaches the barrier which exerts a downward pressure on spot and hence preventing it from hitting the barrier. A similar dynamics is realized for the vega exposure on this trade which is being short near the Strike but long near to the barrier. This will again result in the selling of short dated options and hence suppressing the volatility levels. This makes the spot sticky.

Option delta profile a day before expiry (K=1.4850; KO=1.5500; delta in Euros)

Whenever the barrier is breached, the option gets knocked out and hence the hedges would need an unwound which will result in buying back the spot and options to square this position which can result in a higher gap in spot and the spot is said to be slippy.