FxWirePro: GBP/USD ‘Debit Put Spread’ To Hedge Event Risks

BoE is scheduled for this week, the British central bank’s MPC is most likely to keep bank rate unchanged at 0.75%, a decision that is going to be certainly unanimous.

BoE to acknowledge that a weaker external environment and ongoing political uncertainty have made the case for hiking less compelling.

Yet, conditioned on a ‘smooth and orderly’ Brexit assumption, the economic projections are expected to remain consistent with modest increases in Bank Rate and inconsistent with current market expectations.

While the US Federal Reserve cut its policy interest rates by 25 basis points for the second successive meeting as expected. 

OTC outlook: The positively skewed implied volatilities of 2m tenors have still stretched towards OTM put strikes that indicates the hedging sentiments for the downside risks (1st chart) amid the minor positive shift in RRs (3rd chart).  Whereas, 2w skews are unbiased (4th chart).

To substantiate the downside risk sentiment, risk reversals have still been signalling bearish hedging sentiments despite some positive shift is observed in the bearish risk reversal numbers in the shorter tenors. Hence, we advocate below options strategy on both hedging and trading grounds.

Strategy (Debit Put Spread): Stay short sterling via a limited loss tail hedge: Stay short a 2M/2W GBPUSD bear put spread (1.3050/1.2750). 

The Rationale: Brexit deadline extension has been agreed by the EU, and the UK general election has been scheduled for December 12th, but how exactly the subsequent course of events in the UK plays out is still uncertain.

We perceive a post-general election Conservative majority to likely translate Johnson’s deal into UK legislation in a manner which raises no deal risks at end 2020 as a Conservative majority will bring with it a temptation to reopen the deal to address Brexiteer concerns. Conveniently, the trough of GBP term structure is currently at 1Y tenor, making an outright 1Y to 18M vega ownership attractive. 

From the GBP OTC outlook, amid major downtrend we reckon that the sterling should not suffer like before, but, one should not disregard the UK elections and Brexit settlement risks on the other hand. The market has always ignored the fact that all the current BoE interest rate moves are due to a favourable result of the Brexit process.

The above nutshell exhibits IVs of G7 FX bloc on lower side (2nd chart). The prevailing sideway trend of GBPUSD, IV skews and risk reversals of 1w tenor if you consider, the underlying movement with lower IVs is interpreted as a conducive environment for writing overpriced OTM put options. While the underlying movement with lower IVs can also offer economical OTM option pricing. 

However, the skews and RRs of long-term remain cautious about hedging of bearish risks that encompasses the above stated events (UK elections and Brexit deadline). Courtesy: Sentrix & Saxo