By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman
The options markets may generate insight into the direction of the spot foreign exchange market and what traders may be fearful of. For our purposes here we will look at two measures for the euro, yen and sterling.
The first measure is implied volatility and the second measure is the risk-reversal. Recall that puts and calls struck equidistant from the forward should trade for the same price. To the extent they don’t reflects a bias in the market. Putting the two together is an exercise in foreign exchange forensics and may generate insight into spot and market psychology.
Euro: Here in March 3-month implied volatility is unwinding the run-up seen in February. Near 8% today it has approached its 100-day moving average after peaking near 9.5% in late February. The spot market has gone largely sideways over the past couple of weeks. As the euro was falling from $1.37 to below $1.30, not only did implied volatility increase, but the premium for euro puts over calls was reduced to 0.25,the least since 2009.
However, the slide in the euro saw implied volatility fall, while the premium for euro puts over calls increased to about 1.75%, the largest in five months. Both the lower vol and larger put premium, can be explained by the sale of euro calls (the put premium means call discount). This suggests that as we saw in the futures market, where the net speculative position switched to short euros, the option market was acting as a parallel market to express a similar view.
Yen: The 3-month implied yen volatility is generally flat at its 4-week average near 12%. Implied vol was near 7% when the Japanese elections were announced in mid-November. The risk-reversals are considerably more interesting. Recall that traditionally, Japanese corporates are repatriating dollar proceeds from exports and typically are dollar put/yen call buyers
However, beginning in early 2012, the dollar calls began going for a premium over puts. At the end of last year, as Abe rhetoric was in full bloom, the dollar call premium rose to 1.5%, which is the highest in over a decade. This makes intuitive sense, like the with the euro, the options market was a parallel expression of what has happening in spot.
This has changed. For the first time since early 2012, the dollar puts began trading at a premium to dollar calls yesterday and there is follow through today. It seems now that the yen shorts are buying dollar puts/yen calls and selling dollar call/yen puts. This is being done ostensibly to protect the short yen spot position. That they are choosing to embrace the options market as insurance now is important. It dovetails well with our view that Abenomics is now largely discounted and the short yen story is well known and now a crowded trade. Simply put, this is an early sign that the yen shorts may be getting nervous.
Sterling: As sterling entered a head-long plunge starting in early January, implied 3-month volatility rose from near 5.5% to 9.3% in late February. Although sterling has continued to decline over the past two weeks, volatility has come off and is now about 8.25%. Even when sterling was trading above $1.60 in December ’12 and early January, sterling puts were at a premium for sterling calls. The smallest that premium got to was -0.40. As sterling fell, the premium for puts swell to near 1.4%.
Sterling’s decline to new 3-year lows yesterday did not see new highs in the put premium. It looks like the sterling bears are getting nervous and seeking to use the options market for protection/insurance. There has been talk of 1-month sterling calls/dollar puts struck near $1.55 are being bought. However, the decline in volatility suggest that there may be unreported interest in selling sterling puts on ideas that implied volatility is still high and well above the 50- and 100-day averages.
The take away: Sterling and yen shorts appear to be getting nervous after seeing large moves here at the start of the year. Indicative prices in the options markets suggests there has been a switch from using the options market as a parallel market to using it for insurance. The euro shorts still seem relatively comfortable and the options market is seeing a parallel expression to spot developments.