FxWirePro: Valuation and positioning dislocations in “Ratio Call Spreads” as low premium carry vehicles in EMFX

The ratio spread is a neutral strategy in options trading that involves buying a number of options and selling more options of the same underlying spot price and expiration date at a different strike price. It is a limited return and with unlimited risk options trading strategy that is employed when the options trader ponders that the underlying price would sense little volatility in the near term.

USD/high yielders should be able to trace only shallow grinding moves lower from current levels, especially as their beginning-of-year valuation and positioning dislocations have long disappeared. Thus, ratio call spreads are deemed as low premium carry vehicles if we are correct about a pause in the dollar bear trend and a potential correction higher in coming weeks.

This lends itself to limited premium carry-harvesting option structures; indeed in a recent publication, we showed that the mix of depressed vol levels and elevated carry-to-risk set-up in EM FX is now ideally set-up to deliver the best Sharpe Ratios on carry trades (refer above nutshell), according to JP Morgan.

While standard ATMF vs. ATMS option spreads certainly do a decent job of milking carry as demonstrated in the referenced note, we also favor ratio EM call spreads as lower premium vehicles for achieving the same end because they also take advantage of historically depressed high-yielding FX risk-reversals (the 2nd chart, ratio call spreads are net long risk-reversals by virtue of overselling OTM USD puts/FX calls); we recommended 1*2 USD put/CNH call spreads in these pages in our last publication as efficient ways of playing a potential grind stronger in the renminbi following the recent change in China’s FX policy.