Forex: Purchase of volatility

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09/24/2012 | 05:45 pm
The forex market exchange is the largest OTC market (over the counter), with more than 4 trillion dollars traded each day. In spite of the tensions on European debt, Euro seems saved. Draghi’s speeches and ECB bond plan have reduced the risk of Euro area’s explosion. These plus the Federal Reserve’s plan allowed Euro to gain ground against US dollar. In this context forecast currency cross rates is more and more hard. In order to understand cross rates’ fluctuations we will analyze the implied volatility.
Easing monetary policies and historical low interest rates in all “major” Countries, have allowed minimizing systemic risks and the decline of implied volatility. This indicator is a reflex of market’s uncertainty, the higher the valuation is, the higher the risk of large fluctuations is. At difference of historic volatility, implied volatility considers also an estimation of the future volatility. This indicator is more pertinent and is used in the options’ evaluation model.  
The volatility on cross rate is relatively weaker than on other assets. For example, in October 2008, the S&P500 volatility reached 80% despite of EUR / USD volatility was at 20%.

In the graphic below the 3 months implied volatility on different cross rates.

Blue: implied volatility between EUR/CHF
White: implied volatility between EUR/USD            
Red: implied volatility between USD/JPY
Green: implied volatility between USD/GBP

The 3 months implied volatility of Euro against US dollar is to lowest level since 2008, even since 2007 against Japanese Yen. Sometimes this decline is also caused by Central Banks, like the case between Euro and Swiss Franc. In 2009 the cross rate EUR/CHF has quoted around 1.50, but two years later it was at 1.03, thanks to Swiss Franc’s characteristic of safe asset during European crisis.
On September 6, the Switzerland National Bank (SNB) has announced the plan to set up a bottom level to 1.20. In less than half an hour the cross rate raised to 1.20 from 1.10, and thanks to the Central Bank’s announce the volatility fell from 20% to 8% in less than two days. 
Negative correlation between cross rate and implied volatility on EUR / USD.

Since 1999 we notice a negative correlation between USD/EUR cross rate and implied volatility. When Euro rises against US dollar implied volatility often declines and conversely. In 2000, when the Euro quoted as virtual money, it reached historic lowest level at USD 0.85 while volatility increased. Since 2002, Euro has gained constantly ground against US dollar, reaching the highest level close to USD 1.60. In this period volatility reached the lowest level at 5%. In the middle of financial crisis, in 2008, Euro declined against US dollar and volatility raised.
At the moment the non-correlation trend seems came back after years of low correlation. The past weeks Euro recovery has pushed implied volatility to lowest level since 2008.

In yellow EUR/USD and in white the implied volatility

Who says Volatility says opportunity on options

The options are the only financial instruments, which allow taking benefit from volatility. According to Black & Scholes model, the higher volatility is, the higher is the option premium. This circumstance is explicable by the higher probability to generate positive performance with a long  position when market forecasts larger fluctuations. The short position gains thanks to higher risk premium.

How bet on the current level of volatility

At current conditions, it is hard to forecast the trend on the forex market exchange also due to Central banks’ decisions, but is hard to think that implied volatility stays to these low levels. For this reason, we suggest a long straddle strategy on cross rates. This strategy consists to buy a call and put option. Both options must have the same strike price and the same maturity (3 months). We can follow also a strangle strategy the same idea but the options have different strike price. These strategies allow betting on volatility raise without having an idea of the sense of fluctuations. At current levels of volatility it could be profitable to make a long straddle strategy, in fact in these conditions buy options is cheap. The investor has a positive performance if we assist to fluctuations larger than premium paid to buy the two options. Investors could wait to maturity in order to exercise one of the two options, or sale the options before maturity. In fact with higher volatility the option premium will be higher. 
Investors which forecast that volatility continues to decline could follow the same straddle strategy but on the short side.

The straddle and strangle strategies are positions with unlimited gains and limited losses.

Below the payoff graphic of long straddle strategy on EUR/USD with a strike price of USD 1.30. The break even point is represented by horizontal line.

Oscar Salza
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