An option-based strategy that is mostly used in currency (and interest rate) markets and involves the purchase of a foreign exchange call (put) option and the sale of a foreign exchange put (call) option, at the same time (i.e., simultaneously) and for different strike prices. In other words, this strategy consists of a series of range forwards or collars based on corresponding forward prices or rates in interest rate or currency markets.
In currency markets, a tunnel option allows the buyer to hedge the risk of currency exposure at a reduced cost while is still able to avail from any favorable movements in the exchange rate. The tunnel option can be viewed as a forward trade in currencies that is bounded by a cap and a floor where the strike prices of the call and the put represent the cap and the floor, respectively. A zero cost tunnel can be established by offsetting the cost of the premium on the long leg with the gains from the short leg.
The tunnel option is also known as a cylinder option, flexible forward, mini max, option fence, range forward, equity risk reversal, among others.
