21 January 2011 at 5:43 GMT
While it is no secret that the option market has been somewhat subdued year-to-date, with implied volatilities under pressure and spot markets rangy, we are starting to see signs of increased nervousness hitting the option market.
Wednesday's poor performance of the stock market (albeit not dramatic) seems to have reminded traders that signs of economic recovery might only be just that, and that financial markets should still be treated cautiously. This nervousness has spread to the FX and FX Option markets somewhat.
EURCHF implied volatilities, for instance, were paid up on Wednesday evening on the back of a lower spot… Interesting to see though that most of the buying interests seemed to have been for upside strikes. A higher spot on Thursday (breaking 1.3000 during the New-York session) did therefore not provide any relief in volatilities and new buyers of EUR Calls / CHF Puts emerged, with strikes now above the 1.3100 handle.
This nervous activity is evident in the option market: interbank liquidity all but disappears on in any sharp intraday move, leaving traders struggling to cover short option positions. So far this has not proved to be too much of an issue, as those short term moves have been just that, but a gain in momentum could have much more impact on the market. Similarly, increased buying activity in the option market could well be the precursor to sharper moves in spot, leading to wider ranges and/or significant breakout.
It should be pointed out that the behavior we are seeing is not typical of a risk-OFF move, which broadly characterizes by a flight to safety (JPY, CHF, USD… pretty much in that order). JPY crosses in particular have been supported, and we note some interest to purchase JPY puts against both the USD and EUR (with strike ranging from 85 to 90 and from 112 to 116 respectively). Here again we point to our previous article highlighting the USDJPY risk-reversal behavior over the last year.