FxWirePro: CAD/JPY option strips to hedge both bearish/bullish scenarios in major trend

The Bank of Canada (BoC) is likely to have taken a deep breath when it saw the October inflation data on Friday. It fell from 1.6% to 1.4% YoY. The different measures of core inflation also eased slightly and now range between 1.5% and 1.7%. That means it is quite justified that at the rate meeting in October inflation moved to the top position in the statement. The BoC expects inflation to only return to its target of 2% in the second half of 2018. So far the underlying trend does not suggest otherwise.

However, it should not weaken as otherwise the market will come to the conclusion that the two 25bp rate hikes this year to now 1.0% might have been a policy mistake. The market’s reaction to the inflation data on Friday provided a first taste of what this might mean for the currency: the principally more restrictive approach on the part of the BoC based on solid growth – despite continued cautious words in its statement - could put considerable pressure on CAD.

From last three-four weeks, the prices of this underlying pair have been oscillating between 89.806 and 87.457 levels with more potential on the downside.

Technically, current week prices are attempting breach below 21EMA levels (i.e. 88.1685 levels) and head towards wedge baseline, thereby, one could expect more slumps as both the leading oscillators have been constantly converging downwards to signal weakness (refer weekly chart).

The bearish CADJPY scenario below 84.578 driven by:

1) The US moves ahead on border adjustments or NAFTA negotiations turn sour;

2) Commodity prices fall much further on China/global growth concerns;

The bullish CADJPY scenario above 89.1924 driven by:

1) Global demand pushes oil prices well above $60.

CADJPY is one of the better candidates since recent CAD weakness has undershot recent moves in oil and rate spreads

Hedging Strategy: Option strips (CADJPY)

Contemplating above aspects, we reckon that the underlying pair has equal chances of moving on either side but with more potential on downside, thus, it is wise to initiate longs in 2 lots of 2m ATM -0.49 delta puts, while long in 1 lot of +0.51 delta call of the same expiry, the payoff function of the strategy is likely to derive positive cash flows regardless of swings but more potential from 2 puts are more than 1 call.

The risk is Limited to the price paid to buy the options.
The reward is unlimited until the expiry of the option.

Please note that the trader can still make money even if he was wrong, that means the strategy likely to derive handsome yields in premiums regardless of swings. But the spot FX has to move in the opposite direction really fast. The 1 call bought has to beat the cost of buying all the options and still bring in some profits.