Option strategy prices are typically determined by the level of volatility in the market. In recent months, many foreign exchange (FX) currency pairs have been trading in narrow ranges. Whether it was just a seasonal phenomenon or a structural shift in market volatility, no one can be certain; but it has created challenges for many FX investors who find it difficult to make money in range-bound, narrow markets.
Given an environment of historically low market volatility, and in order to capture the benefits of this low volatility environment, this case study explores how traders and institutional investors can employ popular trading strategies, using traditional vanilla strategies. It also describes the potential risks, as well as suggesting more advanced strategies, such as double no touch (DNT) and European range bet (ERB) options to overcome the shortfalls of vanilla strategies.
A Snapshot of Volatility: What Has Changed?
Figure 1: US Dollar (USD)/Japanese Yen (JPY) Spot Rate History
When we look at volatility levels approximately one year ago, we can observe that three-month implied volatility traded around 11%, with spot three-month historical volatility trading around 9.5%.
As of mid-August 2012 we saw a significant change, with three-month implied volatility trading around 7.5%, and the spot three-month historical volatility trading around 6.4%. It is important to note that these represent the lowest volatility levels in the past five years.
Case Study Examples: FX Options for Low Volatility Markets
In the case study examples that follow, we will uncover the best strategies for taking advantage of these types of low volatility environments, examining the benefits, risks and mechanics of each option type. As far as our underlying currency choice, we have selected to use a US dollar (USD)/Japanese yen (JPY) case study, given that JPY is perceived as a ‘safe haven’ currency, and because the Bank of Japan (BoJ) is supporting the USD below 76.50 and thereby creating a floor for the dollar.
Exhibit I: Selling Volatility Using Traditional Strategies (USD/JPY)
First, we will take a closer look at the more traditional vanilla strategies, beginning with selling a straddle. In this scenario, we sell a straddle, consisting of two options: USD call plus USD put USD/JPY; with both struck at the money (zero delta straddles); US$10m per leg and expiry in three months. The premium received would be US$293,000.
Risk analysis for selling a straddle (USD/JPY)
The potential risks involved in this strategy include: limited profit (premium), with potentially unlimited loss; mark-to-market losses; and short gamma, which means expensive hedging for those choosing to hedge (typically sell-side players) (see Figure 2).
Figure 2: Risk of Selling a Straddle (USD/JPY)
We can also observe the following risks: increased loss as the spot rate moves significantly in either direction; short gamma mostly across the strike prices; and short Vega. We would also need to take a look at the time horizon, and determine the risk features of the strategy over time.
Figure 3: Sell Volatility: Selling USD/JPY Strangle
Exhibit II: Sell Volatility – Selling USD/JPY Strangle
Here we will take a closer look at a second vanilla strategy: selling a strangle. In this scenario, we sell a strangle, consisting of a USD put struck at 76 and a USD call struck at 81; with US$10m per leg and expiry in three months. The premium received would be US$95,500.
Risk analysis for selling a strangle (USD/JPY)
The potential risks involved in this strategy include: limited profit (premium) with potentially unlimited loss; mark-to-market losses; short gamma, which again means expensive hedging (when performing dynamic hedging), and short vega. We can observe lower risk as opposed to the earlier straddle, since strike prices are further out of the money. As a result, the premium received for this strategy would not surprisingly be lower than the straddle.
Figure 4: Risk of Selling a Strangle (USD/JPY)
We can also observe risks such as increased loss, as the spot rate moves significantly in either direction; short gamma mostly across the strike prices; and short vega. We would also need to take a look at the time horizon again.
Figure 5: Time Horizon of Selling a Strangle (USD/JPY)
Exhibit III: A Comparative Analysis: Straddle/Strangle (USD/JPY)
Table 1. A Comparative Analysis: Straddle/Strangle (USD/JPY)
Advanced FX Option Trading Strategies for Low Volatility Markets
Exhibit IV: Sell Volatility (USD/JPY) – Buy a DNT Option
Here we will take a closer look at some of the more advanced FX option strategies that can be advantageous in low volatility markets, including first the DNT option. We will explore the mechanics of DNT strategies and explain how they can help investors seeking higher returns, while limiting potential losses.
In this case study example, we receive US$1m if the market doesn’t trade on any day up until expiry, at 76.50 or below – or at 81 and above. This sample option has a three-month expiry, with premium to be paid of US$230,000 (upon inception date).
Risk analysis for buying a DNT option (USD/JPY)
The potential risks and benefits to this strategy include limited loss (premium); potential profit of US$1m (four times over premium paid); but also potential mark-to-market losses. In addition, the premium must be paid in advance (upon inception date).
If toward expiry, the spot rate trades near the triggers, then the delta and gamma become very high. Here, we can also observe that vega diminishes over time.
Figure 6: Risk of Buying a DNT Option (USD/JPY)
Figure 7: Snapshot: USD/JPY DNT Delta Differences
Figure 8: Snapshot: USD/JPY DNT Gamma Differences
Figure 9: USD/JPY DNT Vega Differences
Exhibit V: Sell Volatility – USD/JPY ERB Option
In this scenario, we buy an ERB option. We would receive US$1m only if at expiry the market doesn’t trade at 76.50 or below, or trade at 81 and above. The option would have a three-month expiry with premium to be paid of US$558,000.
With this option, we would experience limited loss (premium) and a potential profit of US$1m (almost twice over premium paid). Potential mark-to-market losses would be possible. The premium would need to be paid in advance (upon inception date) for this option. It is important to note that there is a lower probability of the range being breached than with the DNT option, hence the lower potential profit than the DNT.
Risk analysis for USD/JPY ERB option
We can observe that the ERB’s risk profile is very similar to the DNT’s risk profile. However, if towards expiry the spot rate trades near the triggers, delta and gamma increase to extreme levels (well above DNT), due to the additional leverage effect.
Figure 10: Risk of USD/JPY European Range Bet Option
Exhibit VI: DNT Options in Emerging Markets: USD/ZAR
In this last case study example, we have chosen South African rand (ZAR) as the underlying currency because it is highly volatile and exhibits high negative correlation with the euro (around -0.7).
If we buy a USD/ZAR DNT, we would receive US$1m if the market doesn’t trade on any day until expiry at 7.95 or below, or 8.95 and above. The option would have a three-month expiry with premium to be paid in the amount of US$230,000.
When buying a DNT option in an emerging market (in this case USD/ZAR), we can observe limited loss (premium); a better leverage ratio or set a wider range between the two triggers; and we can gain a potential profit of US$1m (four times over premium paid). We would experience potential mark-to-market losses; and the premium would need to be paid in advance (upon inception date).
Risk analysis for USD/ZAR DNT option
As the option has a high time value, we should highlight what is happening to the theta in the chart below. In addition, as the volatility of the currency pair is much higher, the risk of hitting the barriers is higher as well. We would experience a better risk reward/ratio, but clearly there is a lower probability of a payoff at expiry.
Figure 11: Risk of USD/ZAR DNT Option
Figure 12: Summary: A Comparative Glance at MTM Three Weeks Later
The environment over the summer months and early autumn in northern regions has been characterised by low volatility, leaving many FX investors with the desire to look beyond traditional FX option strategies to take advantage of this environment.
This has led us to a deeper exploration and comparison of the various trading techniques available for today’s FX market practitioners looking to benefit from expected low volatility. Clearly, we can see that traditional strategies often entail unlimited risk in cases of sudden ‘violent’ moves (as it’s always the case when selling options). We can also observe that buying DNT options can limit the potential loss to the premium paid, which can be more desirable for many investors, who may shy away from the concept of ‘unlimited risk’.
At the same time, DNT and ERB options can provide increased profit potential, as compared with more traditional vanilla strategies. In this study, we have also seen how the implied volatility of the underlying asset determines the risk/reward profile. Ultimately, we realise that it’s important to carefully examine the benefits, risks and mechanics of each option type, to determine the best investing strategy and risk profile for your business.
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