FX Options Insights 11/10/24
The U.S. Federal Reserve's rate-cutting cycle has led to a significant weakening of the U.S. dollar. However, a modest recovery in the dollar, driven by reduced expectations of further rate cuts, has raised concerns about potential further gains in the dollar. Options on EUR/USD, GBP/USD, and AUD/USD reflect these concerns, with risk reversals indicating increased demand for options that benefit from a stronger U.S. dollar. Additionally, the upcoming U.S. election is seen as a risk factor, with a victory for Donald Trump expected to benefit the U.S. dollar.
USD/JPY stands out as perhaps under-priced when comparing FX option volatility risk premiums with their fair value measures for expiry dates, which include the U.S. election on November 5. A important yet unknown factor of an FX option premium is FX volatility, hence dealers substitute implied volatility as a stand-in. Should actual volatility equal indicated volatility over the life of that option, it should cover the premium; the difference potential makes FX volatility a marketable asset. Therefore, implied volatility is the predicted realised volatility and should demand extra premium if the expiry of the volatility risk event, such an election, shows high volatility. Actual/real volatility during a given period in the past is known as historical volatility, and it can offer a fair value basis from which to evaluate implied volatility. When the expiry of benchmark 1-month options incorporated the US election result, USD related implied volatility for those options showed a notable rise. In most situations implied volatility stays high and trades with a substantial premium to 1-month historical volatility to underline the "event risk" premium, but not USD/JPY. When its expiry first caught the U.S. election, 1-month USD/JPY implied volatility rose from 12.5 to 13.75; today it rests at 12.0. While that fair value 1-month historic volatility indicator stays over 13.0 for now, mid-September and 2-month lows at 11.3 are not far away.
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Patrick has been involved in the financial markets for well over a decade as a self-educated professional trader and money manager. Flitting between the roles of market commentator, analyst and mentor, Patrick has improved the technical skills and psychological stance of literally hundreds of traders – coaching them to become savvy market operators!