FxWirePro: Delta risk reversal signals costlier EUR/JPY downside hedging – backspreads reduce hedging cost

The current spot FX is trading at 136.448, we expect dips extending up to 132.522 levels. It is understood that bearish momentum is bolstering as we saw that from delta risk reversal table and technical indications. Hence, aggressive bears can initiate one more ATM put in order to make their existing bear put spread that was recommended last week into put backspread.

Unlike a simple naked put for long term, put backspreads would offer reducing hedging cost by receipt of premiums deploying shorts with shorter expiry as we expect some minor rallies in short run and it would also have an extra long put that have leveraging effects. So, the recommendation for now is to add an extra long on put with 1W expiry to the existing debit put spreads.

Please observe how delta risk reversal numbers are getting higher negative values gradually in a long run (it has almost touched -2 for 1 year expiry). Volatility smiles most frequently show that traders are willing to pay higher implied volatility prices as the strike price grows aggressively out of the money.

With these narrow strike differences, the profit potential is greater, so that the ratio needed is also lower to profit on underlying movement. You want to take this trade if you think this pair can go lower, but not crash below 132.265 (the OTM shorts).

Caution: If you think the pair is going to crash, you should be loading up on put buys in existing strategy. The total cost of the trade is going to be the difference between the prices of the two options.

Since the option you sell will always be lower on the skew curve it means you are getting a better deal on what you are selling compared to what you are buying. It makes this strategy a good one if the skew is running a little hot but EURJPY hasn't rolled over that much.