FxWirePro: Mexican peso sell-off triggers vols surface displacement - Delta hedged call spreads for USD/MXN

The peso sell-off triggered a vol surface dislocation, pushing gamma vols to 15.3 handle, the highest since June, and an even quicker reaction of front-end skews, reaching the highest since the 2016 US Presidential elections (refer 1st chart). The back of the vol curve is lagging the move, with 12M / 3M 25D risk reversals vol ratio at a multi month low.

Delta hedged 1*1.5 ratio call spreads: Front end skews are a notable distortion on the vol surface in the aftermath of this week’s MXN sharp drop. Absent a repeat of this week’s sell-off (red flagged the risks, moved the USDMXN forecasts higher and turned neutral on MXN), fading the dislocation is tempting. The structure would benefit from a quiet (ish) price action on MXN, with the spot preferably drifting higher or at least remaining around current levels.

While the current richness of the riskies is helping to tilt the risk-reward favourably, a few notable risks remain. Namely, selling topside calls exposes the seller to negative impact from realizing spot-vol correlation in the event of a sell-off, while better sentiment could expose the long downside (ATMF) call leg to softer realized vols on lower spot levels. Note that realized spot-vol correlation is performing; however, the trailing nature (3m rolling window) of the realized measure (compared to the forward looking implied measure) makes it less relevant for forecasting future performance. In order to mitigate the risk from spot-vol correlation continuing to perform, 6M or longer maturities could be good candidates for implementing the trade, offering the opportunity of closing the position once a given PnL target on lower implied skews has been reached.

With the above in mind, we take the opportunity to analyse what generally works on the MXN vol surface, on a back-tested basis and from a pure vol standpoint. 1stchart analyses a variety of structures, all for 6M maturities. 

For instance, selling RRs (delta-hedged) works orders of magnitude better than selling ATM vol (2nd chart - bottom, Sharpe Ratio of 0.87 vs. 0.15 over past 5-yrs). Better yet, 1*1.5 ratio USDMXN call spreads (delta-hedged) have been notably a high Sharpe Ratio (1.66) trade to hold over the years. Being long ATM vs. short OTM calls at near vega neutral notionals, the 1*1.5 ratio call spread structure is also well positioned to be selling topside OTM vols, which now are priced heftily after the latest vol explosion. 

Also, 1*1.5 ratio calls come near the optimal ratio to maximize Sharpe (refer 3rd chart). At a Sharpe around 0.75, ratio USD put spreads have been decent trades, but nothing remotely close to the ratio USD call spreads. 

Buy delta hedged 6M USDMXN 1*1.5 ratio ATMF/25D call spread @15.1 choice vs @17.1/17.35 indic vols.

Currency Strength Index: FxWirePro's hourly USD is inching at 54 (which is bullish), while articulating (at 10:43 GMT). 

For more details on the index, please refer below weblink:http://www.fxwirepro.com/currencyindex