FxVolWeekly
05 - Nov - 2021
Short-Dated IV/AV Spreads
The FX pairs that stand out as potentially interesting this week are one-month EURUSD, & one-month USDCAD. In both FX pairs, gamma now looks undervalued on the basis of IV/AV spread and in the case of the EUR on a percentile rank basis as well. At the other end of the spectrum, USDJPY and the JPY crosses generally remain expensive except in the case of CADJPY where it looks somewhat undervalued.
Above is the medium-term chart of one-month EUR implied vol plotted against the actual vol. As we pointed out here last week even though the actuals had been declining the implied were holding up well. That was particularly true ahead of the NFP and Chair Powell testimony. Now with that uncertainty out of the way at least in the short term, the market feels comfortable with selling short-dated options lower and that view seems misplaced. By Friday EUR risk reversals moved only a tad better bid for EUR puts and EUR calls are cheap but not yet at a level where we would buy the skew (i.e. buy EUR calls sell EUR puts).
At the same time, EUR actuals are rising based on our hourly data with two-week running over the six-week measure.
The short-term AUD chart above shows clearly the correction in the AUD at the end of last week. What is a bit surprising is the move lower in the AUD did not lead to any pick up in AUD vols but rather a fairly sharp decline. We would speculate that the backup in short-term AUD bond yields is providing a degree of interest rate support that is in the near term at least limiting the fear of larger move lower. In general AUD vol is negatively correlated to spot with falling vol associated with periods of price appreciation and or consolidation.
The AUD risk reversal (the vol price of 25d delta AUD calls less the vol price of 25 delta AUD puts) did not move lower on the move lower in AUD on Friday, and in fact, moved a touch better bid for AUD calls.
At the same time, AUD long-term momentum calculated using daily data now seems to have turned back up.
CAD three-month IV heads lower while at the same time the actuals are flatlining. Here too we see the front end of the CAD vol curve as cheap but the downside risks to CAD are likely to remain subdued given the short-term yield support. There is a real risk of the Canadian dollar overshooting to the upside and a re-test of the previous cycle low of 1.2010 seems probable. Only renewed commodity weakness or macro global growth concerns would be enough to derail.
Six-month GBP implied vol now breaks above the rolling actuals. GBP risk reversal edged better bid for GBP puts over the week but remain well below their most recent cyclical lows.
Sterling looks like it could easily have a dislocating move lower. Not only is long term momentum bearish we are about to take out the rising momentum uptrend.
While we admit CADJPY has lost a lot of its hourly support this chart is not enough in our view to initiating a short CADJPY trade. Even the longer-term momentum picture is bearish we still want to see clearer signs of momentum divergence. While the Yen weakness may well prove transitory in the near term, the CAD weakness that we saw last week may not persist. If CADJPY can retest the previous cycle high and momentum fails to make a new high at the same time that the pattern we need to see to get confirmation.
Educational Corner
In the table above we are pricing out a 114.30 USD call (yen put) from one week out to one-year using a 7% flat vol and 8% flat vol using a 114 spot and assuming interest rates differentials are zero. The vega of the option is the price in yen pips that the price increases for a 1% increase in implied volatility. As you can see the longer-dated options have more vega in yen pips than the shorter-dated options. But also as you can see clearly, option prices do not become more expensive in a linear fashion. A two-week option using the same volatility is not twice the price of a one-week and a three-month option is not three times the price of a one-month option. Often prop traders will tend to buy short-dated options because they look attractive in terms of leverage. But more often than not short term options will more likely than not expire without value and the position often would be better served by a longer-dated option that is more expensive but represents better value. Time spreads, or the selling of shorter-dated options combined with the purchase of longer-dated options can be seen as an attempt to exploit one of the underlying assumptions of the model.
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Research Director