FXO Market Update - Jan 14
OTC Derivatives Trading
Summary: Most EM currencies trades with an inverted vol curve, short dated options trades with a higher vol than longer dated options. This gives good opportunities to put on calendar trades, buy longer dated options and finance it with selling shorter dated options.
Saxo Bank publishes two weekly FX Options Market Update reports covering changes and updates on the FX Options and FX Volatility market. They describe changes in FX volatility levels, risk premium and ideas how to trade based on these.
Most of the EM currencies trades with inverted vol curves, where the front end vols trades higher than the longer dated vols. This gives good value to do calendar structures where you buy longer dated options and finance it by selling shorter dated options. The market consensus trade is for stronger EM currencies going forward and buying EM calls would also benefit from the interest carry. USDZAR is up more than 5% this year on back of the new strain of the corona virus in South Africa and how the government handle the pandemic. The higher spot offer good entry for a stronger EM trade but we still see risk for higher spot. Most of the other EM currencies have started the year range trading to trading just small weaker on back of the higher USD and US yields we seen over the last week.
For example, USDMXN has traded in a 19.65/20.25 range since end of November and the vol curve still trades inverted, which is unusual when spot been range trading for this long. A trade we like in this situation is buying a longer dated put and finance it with selling a strangle.
Buy 1month 19.7500 USDMXN put
Sell 2 weeks 19.6500 USDMXN put
Sell 2 weeks 20.0500 USDMXN call
Receive 100 pips
Or with a longer dated structure
Buy 3 months 19.7500 USDMXN put
Sell 1 month 19.6000 USDMXN put
Sell 1 month 20.2000 USDMXN call
Cost 60 pips
Spot ref. 19.8200
Both structures are close to zero cost which means you will own a very cheap put if spot close between the strikes of the strangle at expiry. Risk is if spot goes higher and you get exercised on the call, but this would give you a better entry for a short position compared to current levels. If spot close below the put when the strangle expires you will then buy USDMXN spot below the strike of your long put. This will generate a profit of 1000 pips in the 2week/1 month structure, and you still got 2 week left on the long put. Risk is that you miss out of a large move lower if it happens before the strangle has expired.
- The Top/Bottom charts shows the top 5 and bottom 5 values/changes for at-the-money vol, risk reversal (RR) and risk premium of the 45 currency pairs we are tracking.
- Risk premium: Implied (Imp) minus realized volatility. A positive risk premium means implied volatility trades above realized volatility, i.e. the implied volatility can be seen as “rich”.
- Change: The difference between current price/volatility and where it closed 1w ago.
FX Options Trading:
You should be aware that in purchasing Foreign Exchange Options, your potential loss will be the amount of the premium paid for the option, plus any fees or transaction charges that are applicable, should the option not achieve its strike price on the expiry date
If you write an option, the risk involved is considerably higher than buying an option. You may be liable for margin to maintain your position and a loss may be sustained well in excess of the premium received.
By writing an option, you accept a legal obligation to purchase or sell the underlying asset if the option is exercised against you; however far the market price has moved away from the strike. If you already own the underlying asset that you have contracted to sell, your risk will be limited.
If you do not own the underlying asset the risk can be unlimited. Only experienced persons should contemplate writing uncovered options, then only after securing full detail of the applicable conditions and potential risk exposure.