FxWirePro: GBP/JPY debit put spread options strategy ahead of Brexit vote

FX traders want simple rules to follow when trading. They work in a market that has become so fast there is no time to contemplate the news flow. Machines evaluate the news flow and provide trade parameters for how they are to react to the developments in the world. In particular in case of a foreseeable event like the vote on the Brexit deal in the House of Commons the majority of liquidity providers in the FX market are likely to proceed like that. Whether it makes sense or not one has to go along with it if everyone does it. Sometimes the FX market acts like a flock of sheep. 

The issue with that is: machines need well-defined metrics. Due to its need for simple rules the FX market tends towards an over-simplification. 

At present, everyone is focusing on the number of votes Prime Minister Theresa May is going to be short of when it comes to the Brexit deal she negotiated with the EU (hardly anyone believes that Parliament is going to accept the motion). If you read the research provided by the competition you will be presented with different scenarios. Between 40 and 80 votes short of a majority are seen as the watershed between GBP-positive and GBP-negative and as far as the initial market reaction is concerned that is therefore likely to be true. The flock of sheep follows its own logic. 

OTC outlook and Hedging Strategy: Please be noted that IVs of this pair that display the highest number among entire G10 FX universe.

While the positively skewed IVs of 2m tenors signify the hedgers’ interests to bid OTM put strikes upto 139 levels (refer above nutshells evidencing IV skews). 

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, 2m skews to optimally utilize delta longs.

The execution: Capitalizing on any minor upswings , we advocate shorting2m (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. 

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.

Every underlying 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: commerzbank

Currency Strength Index: FxWirePro's hourly GBP spot index is flashing -113 (which is bearish), while hourly JPY spot index was at 20 (mildly bullish) while articulating (at 11:29 GMT). For more details on the index, please refer below weblink:

http://www.fxwirepro.com/currencyindex