EURUSD vols have been a notable casualty of the recent market gyrations resulting in USDPLN – EURUSD ATM vol spread at 2-sigma low (basis 1-yr lookback window), a defensive dislocation worth fading, given the attractive risk/reward for buying a higher beta vol at a tight premium. Historically, such undershoots tend to be short lived, although catching the right timing can prove challenging (refer 1st chart).

2nd chart beta-to vol analysis indicates PLN to be a strong buy which in conjunction with the USDPLN - EURUSD vol backdrop allows for entering a defensive long high beta / short low beta vol spread that should hold well, given the favorable entry level.

We back-test a simple trade timing strategy of initiating long USD/PLN vs. short EURUSD at times when their vol spread drops below -2 sigma on 1-yr z- score. The red dots in 1st chart mark the entry points. The analysis shows the bulk of P/L coming within first two weeks and peaking around the 1-month mark with the distribution of the historical returns displaying favorably fat right tails, in line with the long high beta / short low beta characteristic of the vol spread.

Fading the current 2 sigma dislocation, should have potential of producing 1.5-2 vol of P/L. The real nugget is in the fat right tail characteristic that historically tend to align particularly well with the late cycle dynamics. If late cycle is to take hold more forcefully, the vol spread could realize 4-5vol of P/L. Front tenors are the preferable expression but the current liquidity conditions force tenor extension: Long 1Y USDPLN delta-hedged straddle @9.55/10.75 vs short EURUSD delta-hedged straddle @8.35/9.05, in equal vega notionals. Courtesy: JPM