FxWirePro: Capitalize on shrinking GBP vols with positive shift in risk reversals and well-balanced skews - Add Theta shorts in Credit Put Spreads

Please be noted that the GBP IVs have been progressively shrinking away.

The cable volatility surface has returned to levels seen at the start of the year overall, while risk reversals have slightly shifted into positive flashes but bearish risks have prevailed on a broader perspective. Please be noted that the 2w ATM puts are priced 16% more than NPV, while IVs of these tenors are shy above 8%, hence, we could foresee this as a disparity.

Consequently, the credit put spreads now seem excessively attractive as the IV skews of 1m tenors are well balanced on either OTM call or put strikes.

GBPUSD is foreseen for a lower high to develop under 1.3270, but the pace of the move through key resistance levels suggests we could retest those highs, if not set a marginal new high. We still view the 1.3250-1.3346 region as significant resistance and ideally the top of a medium-term range. As such, a decline through 1.3120 and then 1.3040/00 supports is needed to suggest a top is developing. JP Morgan has forecasted this underlying pair to hit 1.30 by the year end.

The sell-off in the cable skew is exaggerated compared to ATM volatility since the risk remains asymmetric on the downside, the tail risk is mispriced.

Thus, we advocate initiating shorts in 2w ITM puts with positive theta, and longs in 2m ATM -0.49 delta longs. The execution is achieved at the net credit.

Theta impact:

For a short option position, Theta is positive; time decay is bad for a buyer, good for an option writer.

In the GBPUSD platform’s sensitivity table, Theta is given as an amount in the traded pair’s secondary currency, for an instance, 2W ATM theta here is -27.72 which means on every 1-day completion option value is likely to wipe off by USD 27.72. 

Theta is not a constant, it changes as the underlying market moves and time passes.

The Theta of ATM options would be of upper values and is likely to increase as time elapses nearer to maturity. If you are holding an ATM option and expiry is approaching, you might be better off closing out of your position.

Option sellers can reap the benefits of a high Theta near expiry by selling short dated ATM options with the expectation of little to almost no market movement.

For ITM and OTM options as the time to expiry draws nearer, Theta lowers and decreases, likewise the premiums on GBPUSD 1% ITM strikes would have been wiped off along with time decay. Simultaneously, long leg in ATM delta put of longer tenor would arrest potential slumps in the major downtrend.