13 January 2012 at 9:07 GMT
Options´ implied volatilities give an insight into both the current behaviour of financial markets and their expected volatility and the FX options market is now at a crucial juncture.
On the one hand, some currency pairs are moving a great deal, with for instance EURUSD closing the year on the lows. On the other hand though, some pairs such as USDJPY or GBPUSD remain lacklustre. As for CHF a long period of low volatility could be followed by a short period of extreme movements (from intervention or other). It is therefore important to look at volatilities in the context of what has been happening and what could happen over a short to medium-term horizon.
The below chart displays three-month At-the-Money implied volatilities for five major currency pairs since mid-2006. Clearly, implied volatilities have increased over this five-year period, spiking to record highs in the fall of 2008, but it is important to note that volatilities themselves have become a lot more volatile! This is of course not surprising: the global financial crisis has made markets a lot more uncertain and liquidity has dried up a great deal.
That said, a few things do stand out: despite the recent developments in the European situation, implied volatilities in EUR-centric pairs (EURUSD, EURCHF, EURGBP for instance) still seem to provide decent upside potential. A premise to the 2008 turmoil was a huge widening in credit default swaps for financial institutions and the failing of many of those institutions. Replace “financial institutions” with “European countries” or “sovereign entities” and you have a somewhat valid statement describing the situation today. It is therefore easy to imagine that a worsening of the financial crisis would lead to implied volatilities reaching and surpassing the extreme levels seen in 2008.
In addition, some currency pairs such as USDJPY, GBPUSD or USDCAD are actually seeing their volatilities at a relatively low level compared to the last three years. This is symptomatic of the crisis being perceived as EUR-centric. A failing Europe would hardly leave the rest of the world unscathed. As such, long option positions, in say USDJPY, could provide a great deal of leverage to the astute investor: offering great potential whilst facing a somewhat limited downside.
Owning options could prove to be an invaluable addition to an investment portfolio - more so now than ever, as we continue to face what could become a perfect storm financially, economically, politically and sociologically. Let’s not be deterred by what might, at first glance, appear to be high implied volatility levels; those could easily prove to be cheap entry levels.
Download the entire Saxo Bank Q1 Quarterly Outlook.