Volatile, Binary, Pound Outlook Leads to Surge in Demand for Option Contracts

Image © kasto, Adobe Stock

- Volatile outlook for GBP prompting increase in options trading

- Rise in the 'straddle' strategy enables profiting from the volatility

- Cost of trade rises to 160 basis points

The increasingly 'binary' outlook for the Pound is lending itself to a specific type of trading strategy which rewards big moves regardless of direction.

In the event of a 'no-deal' the Pound would be expected to capitulate, whilst if the UK and E.U. manage to agree on a deal the Pound could see massive gains.

The one thing the market can be sure of is that there will be a big move in one direction or another - it's the direction which is in question.

FX traders have developed a specific type of strategy to profit from these sorts of market conditions in which a high degree of volatility is expected, and that strategy is called a 'straddle'.

It uses options contracts, which are a type of FX derivative which enables leverage and at the same time limits risk.

"Brexit uncertainty is a certainty, so GBP options look good," says Richard Pace, an analyst on the Thomson Reuters currency desk. "Headline-driven GBP volatility stirred up by Brexit negotiations is making it tough to play the cash market, but it has rewarded those long of options and should continue to."

How does a 'Straddle' work?

A simple straddle trade involves simultaneously buying a call option (bullish bet) and a put option (bearish bet) at the same price (the strike price).

Assuming there is a great deal of volatility one of the bets will make a lot of money, whilst the other bet will expire worthless on its expiry date (usually between a month and a year ahead).

The only cost of the trade is the purchase of the two original option contracts, also known as the option premium.

If there is a lack of volatility both options are left to expire worthless or closed at a loss.

Strong Demand

The high degree of volatility ahead is already driving up option premiums. The cost of straddles has risen to 160 basis points as traders look to profit on big moves and others such as corporates look to use any returns to cover any potential losses should the exchange rate move against them.

"One-month and two-month expiry implied volatilities have also posted new long-term highs today, to highlight the expected spot volatility ahead," says Pace.

Image courtesy of Thomson Reuters.

The more optimistic outlook for Pound Sterling which dominated the market last week when rumours of a deal kept GBP well-bid increased premiums for calls but these have since dropped as talks stalled over differences on the Irish backstop.

A call is an option that delivers a profit if the exchange rate rises, whereas a put delivers profit on a decline.

"No-deal Brexit fears have been apparent for many weeks, keeping the GBP put versus GBP call implied volatility premium at long-term highs – highlighted by risk reversals along the curve," adds Pace.

'Risk reversals' measure the cost of protection against bets going wrong. They are the ratio of call prices over puts.

A positive risk reversal, therefore, indicates calls being more expensive than puts, in other words, the upside protection on the underlying forex spot is relatively more expensive because there is more demand for calls (bullish bets). This means the market expects higher prices.

Comparatively negative values indicate puts are more expensive than calls, in other words, downside protection is relatively more expensive, and the market expects the underlying asset to fall.

This appears to be the situation with GBP risk reversals.

Image courtesy of Thomson Reuters.