Q4 FX Options: Focus on EURUSD and EURCHF

EURUSD continues to be under a great deal of pressure. This has been apparent during September, not only in the spot market (falling 7 percent from 1.4500 down to 1.3500), but also in the options market: interest in purchasing downside protection have been plentiful, pushing EURUSD implied volatility to fresh highs as well as ensuring that risk-reversals keep a hefty bias for EUR puts / USD calls (downside options). As a guide, we saw one-month At-The-Money (ATM) implied volatilities as high as 17 percent, up 5 vols from the end of August. One-month 25 delta risk-reversals were showing a bias of around 4 percent for EUR puts, up 1.20 vols for the same period. This options buying has not been limited to short dated options: one-year ATM implied volatility and risk-reversals being up 2.5 and 1 vols respectively.

Such price action suggests that demand for downside protection (or leverage) far outstrips supply; clearly FX options market-makers are struggling to absorb those flows, leaving the market extremely vulnerable to further EUR weakness: on a lower spot, major option market-makers will find themselves managing significant short gamma and vega exposures which in turn could mean an acceleration of the spot moves.

As such, and despite the current high level of volatility, we would be extremely cautious towards any short EUR downside option positions, and would rather lean towards a long option position aimed at benefiting from a lower EURUSD spot.

The EURCHF options market is also worth looking at. Following the Swiss National Bank intervention, the price action in FX options implied volatility was as dramatic as it had been in spot. One-month ATM volatility currently stands at 7.0 percent, down an impressive 15 vols from the level seen prior to the SNB’s actions. Going long EURCHF has been a popular speculative trade since that day - either through spot or through selling EURCHF puts with strike at or sub the 1.20 level. Indeed this is a very tempting proposition: SNB has been unequivocal in its intentions to protect 1.20. It now enjoys local and political support and the ability to print more money should guarantee a successful result.

But whilst it is hard to see them fail, it is worth considering what might happen if they cannot protect this level. A change in local sentiment, political support or even a EUR breakdown might just prove too much for the SNB, and the all important 1.20 level could give way (whether completely or through a re-pricing exercise). Such an event would, no doubt, trigger a very sharp rise in implied volatility. Therefore short downside options positions in EURCHF should be traded very cautiously as they could prove extremely costly if SNB fails. Investors looking to benefit from a sucessful SNB action might consider entering short EURCHF put spread positions rather than outright options. This would allow for a very controlled risk should 1.20 give way.