FxWirePro: Capitalize on 1w1m GBP/JPY IVs and arrest further downside risks via diagonal collars ahead of UK CPI report

British consumers powered the economy through June’s Brexit vote and beyond, but many economists ponder accelerating inflation would weigh on household spending this year. Consumer-price data, as well as measures of producer-price inflation and house prices, would shed some light as to how the slide in the pound since Brexit is feeding into the prices faced by businesses and consumers.

Sterling’s weakness since Brexit vote is pushing up prices of fuel, food, and clothes, official figures to show, as a result, inflation in the UK is set to hit its highest level in more than two years this week.

British consumer prices rose 1.2 pct in a year to November 2016, compared with a 0.9 pct growth in October and above market expectations of 1.1 pct gain, and economists expect it to have picked up to 1.4% in December, with more gains seen in the coming months.

Before we begin with hedging framework, we would like you to know GBPJPY’s intermediate bull trend has exhausted and major downtrend resumed, which was advised in our recent technical posts. Please go through below weblink for more readings: 

http://www.econotimes.com/FxWirePro-Daily-Shooting-star-on-GBP-JPY-evidences-slumps-below-DMAs-and-strong-support-major-trend-to-resume-on-monthly-shooting-star-occurrence-489096

http://www.econotimes.com/FxWirePro-GBP-JPY-8-weeks-uptrend-edgy-as-shooting-star-resumes-bears-in-major-trend--Short-via-tunnel-spreads-463037

OTC updates and hedging strategy:

Well, in the recent times, GBP vols skews normalized too much after the Brexit votes, the GBP volatility market normalized sharply (you could observed that in GBPJPY IV skews) which is quite favorable for OTM call option writers but 1m IV skews still signal downside risks owing to harder Brexit. The liquidity recovered and the extreme positioning was ultimately absorbed. The price action is not taking the direction of an imminent new trend. As a result, the option market aggressively unwound smile positions.

The trend monitoring: the major downtrend and short-term upswings into consideration, anyone who wishes to carry long GBPJPY exposures, a collar options trading strategy is recommended. This could be constructed by holding a total number of units of the underlying spot FX while simultaneously buying a protective put and shorting call option against that holding. The puts and the calls are both OTM options having the same expiration month and must be equal in a number of contracts.

The collar is a good strategy to use if the options trader is writing covered calls to earn premiums but wish to protect himself from an unexpected sharp drop in the price of the underlying security.

Technically, the collar strategy is the equivalent of an OTM covered call strategy with the purchase of an additional protective put. Capitalizing on 1w IVs and 1m IV skews, we prefer OTM shorts that likely to reduce almost 50% cost of what you pay in the form of the premium on OTM longs.