Turn of the skew: FX options dealers balance fragile market

Calls-versus-puts demand flips wildly in response to geopolitical events

Key points Summary Q&A

• Macro hedge funds benefitted from foreign exchange volatility in Q2, while options dealers faced market challenges.
• USD shorts have become one of the most crowded trades according to Bank of America strategists, with sentiment hitting historic lows.
• Traders experienced sharp movements in risk reversals – the difference between puts and calls – complicating the management of FX options exposures for dealers.
• Risk reversals, also known as skew, flipped wildly in response to geopolitical events in June and July. 

These summaries are generated by an LLM, but edited by humans.

Macro hedge funds like Rokos Capital Management and Bridgewater may have profited from foreign exchange volatility during the second quarter, but for options dealers the market has become increasingly precarious.

Since US president Donald Trump’s explosive tariff policy announcement in April, positioning has been firmly geared towards US dollar weakening across G10 currencies. A July 11 research note from Bank of America says USD shorts had become one of the most crowded trades, with dollar sentiment and exposure at historic lows.

Strategists at HSBC had also compared the relentless dollar selling during the second quarter to “‘bubbly-like’ behaviour” that will eventually pop. 

For liquidity providers, a series of ‘mini-corrections’ since April has meant holding this position – and hedging it – can be tricky.

Sharp movements in spot and risk reversals – the pricing differential between puts and calls – often spell trouble for FX options market-makers managing their exposures.  Exotic parameters such as vega – the sensitivity to movements in volatility – and gamma, the rate of change of an option’s delta for a change in spot, can whip around wildly in yo-yoing markets.

Constant flip-flopping in skew may indicate clients seeking to exit their risk-on positions as quickly as they re-enter a risk-off trade

When risk reversals – also known as skew – are trading at a level where the demand for call or put options can easily flip, so too can the gamma profile of dealers.

Given how quickly the market can retrace after negative impacts stemming from unpredictable geopolitical events, dealers taking a cautious approach and covering their gamma exposure can easily find themselves over-hedged as volatility settles.

Take positioning in euro/US dollar FX options, where market sentiment shifted sharply in response to several headlines over the summer.

On June 12, the euro had appreciated to 1.16 against the dollar. One-month risk reversals – a measure of the volatility of upside calls struck out-of-the-money, typically at the 25-delta point, minus the volatility of puts at the same level on the downside – traded at 0.76, indicating a higher premium for calls on the pair.

After Israel launched an overnight attack on Iran, the dollar strengthened slightly to just below 1.15 as hedge funds took profit on their shorts. At the same time, skew nosedived.

By the time the US intervened with its strikes on Iran’s nuclear facilities on June 22, skew flipped to -0.53 in favour of euro puts as the dollar strengthened. A couple of days later, skew reverted to positive as geopolitical tensions calmed.

This aggressive repricing event in front-end volatility demonstrated that traders still hold the consensus view that the dollar can be a safe-haven currency when geopolitical risk occurs.

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Since July, skew has declined as the dollar strengthened. On July 14, the US Dollar Index closed above its 21-day average for the third day in a row – the first time this has happened since May. By July 16, one-month risk reversals hit -0.17.

Things then got rocky. Later that day, when reports emerged that the US president was preparing to fire Federal Reserve head Jerome Powell, EUR/USD spot jumped 1.31% in an hour, while skew sprang back to 0.26. While spot retraced quickly even before Trump poured cold water on the reports, skew remained positive at 0.07 the following day.

Dealers say these instances highlight clients’ jumpy response to headline risk. The constant flip-flopping in skew may indicate clients seeking to exit their risk-on positions as quickly as they re-enter a risk-off trade, with many willing to cross spread at each price increment.

At the same time, dealers seem to have become desensitised to Trump-generated headlines. If markets suddenly lurch on the back of a social media post or a flippant comment at a press conference, dealers have had plenty of opportunity to anticipate a reversal and trade in the opposite direction.

Now that the US has struck a trade deal with the European Union, EUR/USD sold off aggressively on July 28 and risk reversals have once again switched to favour euro puts. The short US dollar trade could still be the long-term play, but elevated front-end volatility may mean this position continues to flip in the short-term.

Anyone relying on the traditional August lull for a period of quiet relaxation may be disappointed. FX options traders, who revel in volatility, will have to remain on their toes all summer long. 

Editing by Helen Bartholomew