FxWirePro: Sterling Dynamics and Options Combinations on Low IVs Play

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. 

The above nutshell exhibits IVs of G7 FX bloc on lower side. Considering the prevailing sideway trend of cable, the underlying movement with lower IVs is interpreted as a conducive environment for writing overpriced OTM options. While the underlying movement with lower IVs can also offer economical OTM option pricing. 

Amid low implied volatility era, we consider options combinations using calendar structures.

One theta- efficient alternative is to consider partially financing ATM straddles with writing 10D strangles. 

Selling low-delta wings around potential large dislocations such as a no-deal Brexit seems dubious but the above chart (2nd exhibit) clearly demonstrates a value of such construct. 

While systematically buying GBPUSD straddles delivers a familiar, predictably negative return stream typical of long volatility structures, if one were to combine such straddle longs with 10D strangle shorts in less-than-even vega amounts (equal vega amount would correspond to 1.0:2.5 notionals sizing), the risk-reward profile changes favorably.

Namely, the straddle – strangle package turns out to have 0.6 beta to standalone straddles but exhibits a decay of only about 1/3ed to -1/5th of that of straddles. 

Hence, consider the below options combinations: 

Go long in 1Y GBPUSD or GBPJPY straddle, delta-hedged, @8.6/9.25 and @10.0/10.6 indic, respectively. 

Or in a format of a low decay spread as 

Adding 1Y GBPUSD straddle vs 10D strangle, delta-hedged, @1.05/1.35 indic, equal USD notionals. Courtesy: JPM