FX traders dump short-dated options on Brexit mire

Attention turns to long-dated positions after failed no-confidence vote

Brexit drop
Infopro montage

Foreign exchange options traders have jettisoned short-dated sterling-US dollar positions following the failed no-confidence vote against UK prime minister Theresa May yesterday, as attention shifts to longer-dated expiries in the New Year. While traders say liquidity concerns have eased, the constantly changing situation has scared some hedge funds off the trade altogether.

“We're really in uncharted territory here on so many levels. I think [moving forward] it’s going to be very choppy, but it feels like the pressure has eased a bit in the short term,” says one interdealer broker.

By early afternoon on Thursday (December 13), implied volatilities on two-week and three-week sterling-US dollar options had shed roughly 3 and 2.5 volatility points from their overnight highs. While traders are now generally targeting dates in January and February, options expiring in those months were also down roughly 2 and 1.6 points, respectively.

Andrew Soper, Crédit Agricole CIB’s global head of foreign exchange options trading, says short-dated volatility was priced high, but there wasn’t enough volatility in spot to sustain it, and the downward adjustment took the longer expiries with it.

“We’ve seen how very quickly the market can adjust when immediate concerns around Brexit calm,” says Soper.

“Basically, the market has decided we see nothing of note until the New Year, so the premium embedded in the curve is too high,” he adds.

One-week option volatility though remained above longer-dated expiries, despite dropping 3.8 points, given the possibility for new developments during the European Council meeting scheduled for today (December 13).

As vols come off across the board, risk reversals – the difference in implied volatility between a 25 delta call and 25 delta put – for options beyond one week have remained at negative levels close to those at the start of the week. This implies that the price of downside protection on the sterling-US dollar rate remains higher than upside positions.

The ongoing uncertainty has continued to keep international investors out of the market, and some hedge funds have even lost interest given the unpredictability, says Julian Weiss, a foreign exchange options trader at Nomura in London.

Aside from some far out-of-the-money options written this month – including a $15 million below-parity put set to expire in early March, and a $147 million, two-year call for $1.71 – positioning remains relatively muted with strikes clustered between $1.25 and $1.38, according to swap data repository information.

A choppy ride

For weeks now, forex options traders have had to contend with a moving target of Brexit-related dates and political risks. The drama accelerated this week, leading to whipsawing implied option volatilities and what the interdealer broker earlier in the week called a “pretty chaotic” environment.

On Monday, when the UK prime minister cancelled the scheduled parliamentary vote on the withdrawal agreement, implied volatilities on one-week options fell, while those on longer-dated options rose. The moves, traders say, reflected the assumption that the following weeks would be relatively calm and that the important dates would now be on a vote in the New Year. 

But when reports that Conservative members of parliament were closing in on the number of letters needed to trigger a vote of no confidence in the PM, volatilities quickly repriced higher late Tuesday – only to fall Wednesday afternoon as reports suggested May would have the votes she needed to win.

After a third of Conservative MPs expressed their lack of confidence in the prime minister on Wednesday night, implied volatilities on one- and three-week sterling-US dollar options rose, while vols for options dated for the near-Christmas expiry fell.

Then when traders came in Thursday morning “everyone sitting on vol longs just hit the sell button”, says a forex trader at one dealer, on the assumption that sterling moves would stay muted until January.

“The clear theme in the vol market that we have observed now for over a week is that all the larger banks have asked to sell one-month dates or options expiring just in the beginning of Jan, and against that buying end of January or early February – two months and out,” the trader said.

Holiday illiquidity

The developments come as the market nears a traditionally less liquid holiday season. But falling vols suggest traders are less concerned with political events towards the end of the year when liquidity typically thins. Trading volumes in sterling-US dollar options were higher this week, with volumes through Wednesday nearly double those from the same period last week, according to data from the Depository Trust and Clearing Corporation.

Still, bid-offer spreads remain elevated at roughly twice the 2018 averages for overnight to one-year tenors.

The mixed picture of liquidity measures contrasts the situation last week, where at least one market-maker and broker said illiquidity – combined with the normally quiet holiday season – could lead to oversized market moves.

The liquidity situation reversed earlier in the week, says the broker, as more people were willing to buy and sell.

Simon Manwaring, head of currencies trading at NatWest Markets, says liquidity concerns may be unwarranted for now since “liquidity is actually functioning quite well” given the uncertainty and time of year.

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