FxWirePro: GBP/JPY IVs Buzzing on Brexit Month – Time For ‘Put Ratio Back Spreads’ Capitalizing on Highest IVs

The next hot Brexit phase has begun in October, yes, the public attention focuses on the question as to whether a Brexit deal is possible by the end of the month. The chances of that are obviously low. What is more important is the question of what happens if no deal has been reached by 19th October. Will the British Prime Minister - as the Benn Act requires him - ask for an extension, will he rather be “dead in a ditch” or will Boris Johnson find a loophole after all? There is nothing on that in the current news flow. And that is why GBP has not moved much since the slide on Tuesday.

The optimism that initially greeted the publication of PM Johnson’s Brexit proposals this week has already started to fad. Even so we believe it worthwhile increasing our bearish beta to GBP through re-selling GBP/JPY (our single most successful trade to date this year). The lead- up to the EU summit on October 17-18 will become increasingly fraught from a political perspective. Johnson may well apply for an extension but that won't buy GBP any real breathing space - all it would do is create the space for an early general election which on the basis of the current opinion polls Johnson would narrowly win. 

OTC outlook and Hedging Strategy: The implied volatility of this pair that display the highest number among entire G7 FX universe (see 1st nutshell).

While the positively skewed IVs of 3m tenors signify the hedgers’ interests to bid OTM put strikes up to 127 levels (refer 2nd nutshell). 

Accordingly, put ratio back spreads (PRBS) are advocated on the hedging grounds. Both the speculators and hedgers who are interested in bearish risks are advised to capitalize on current abrupt and momentary price rallies and bidding theta shorts in short run, on the flip side, 3m skews to optimally utilize delta longs.

The execution: Capitalizing on any minor upswings , we advocate shorting 2m (1%) OTM put option (position seems good even if the underlying spot goes either sideways or spikes mildly), simultaneously, go long in 2 lots of delta long in 2m ATM -0.49 delta put options (spot reference: 131.64 levels). 

The rationale for PRBS: Well, the traders tend to perceive these trades as a bear strategy, because it deploys more puts. But actually, it is a volatility strategy.

Hence, entering the position when implied volatility is high and anticipating for the inevitable adjustment is a wise thing, regardless of the direction of price movement. Based on volatility and time decay, the strategy is a “price neutral” approach to options, and one that makes a lot of sense.

The position is a spread with limited loss potential, but varying profit potential. The degree of profit relies on the strength and rapidity of price movement. The position uses long and short puts in a ratio, such as 2:1 or 3:2, to maximize returns. In most long/short spreads, you make money if the stock moves, but you lose if it remains in the middle “loss zone.” A ratio put back spread is different because it creates a net credit, so even if the underlying spot FX price does not move very much, you keep the credit if all of the puts expire worthless.

Please note that every underlying spot move towards the ITM territory increases the Vega, Gamma and Delta which boosts premium. As you could observe spot GBPJPY keeps dipping, these delta longs would become in the money, while these derivatives instruments target further bearishness of this pair. Courtesy: Sentrix & Commerzbank