Sterling has been blasted lower after BoE governor Carney cast doubt on a previously pretty-much-expected UK May rate hike. The EU's rejection of Britain's latest Brexit-Irish border plan only served to deepen the rot.
Article / 17 June 2016 at 14:30 GMT

FX 4 Next Week: The most volatile of votes

Head of FX Strategy / Saxo Bank
  • Traders should know when to move to cash
  • Volatile markets demand small trade sizes
  • Other side of Brexit vote should be calmer
  • Long-volatility options one possible strategy

English Channel
Next week, Britons decide on the legal and institutional significance of the English Channel. In our view, traders seeking to profit from the Brexit ballot should tread carefully. Photo: iStock

By John J Hardy

Next Thursday’s UK referendum is one of the most anticipated event risks in modern market history with endless speculation on the direction the vote will take, the margin of victory of the vote, and the likely direction and magnitude of the market moves in its wake, particularly in sterling. 

Potential volatility is extremely high and the polls and oddsmakers are showing near-total uncertainty regarding the expected outcome. Those looking to trade the referendum outcome in options really should have done so long ago, so this week’s four trading themes are dedicated to reminding traders above all to trade with care, to respect the potential fireworks this week, and to not necessarily trust the initial market reaction to the referendum vote.

Keep powder entirely dry

Sometimes not trading at all is an option, and next week is one of those times. Therefore, traders may find that patience is the best virtue over the next week and then some, keeping powder dry until at least the other side of a referendum. 

Trading stance: Not trading at all, very modest option trading, or cross-hedge trading (see “trading around the edges” below) ahead of the event if the market gets overaggressive in pricing an expected outcome one way or another. 

Trade small 

Traders need to respect the magnitude of potential intraday moves in the currency pairs they are trading whenever market conditions heat up. Intraday volatility is likely to reach white-hot intensity in the hours after the referendum vote and the subsequent few days, so traders will need to vastly reduce position sizes (when trading at all) to maintain market exposure without undue risk. 

Trading stance: Traders will look to preserve capital and respect market volatility by trading in small fractions of normal trading size and scaling into positions.

Trade mostly after the fact

The market action leading up to next Thursday’s vote is likely to be very treacherous and choppy, with the possibility of violent intraday swings on new poll numbers, particularly after the tragic death of pro-Remain MP Jo Cox this week. 

As well, the initial reaction to the referendum outcome may not be worth trusting. Extensive kneejerk GBP weakness in the wake of a Brexit vote may quickly fade in the near term even if the longer term direction is lower, partly on official intervention to ensure liquidity and partly on simple relief that the event is in the rear-view mirror. 

One advantage of trading in the wake of the outcome itself is that options volatilities, particularly in the event of a Bremain result, will likely drop very quickly. EURGBP upside could be one of the quickest developments to fade in the event of a Brexit vote as the focus shifts to the longer term concerns on the EU’s viability from the UK leaving. 

Short-term trading in a Bremain scenario (risk-on) may be more straightforward than in a Brexit scenario.

Trading stance: For either outcome, traders may look for technical patterns to emerge on intraday charts or to fade the initial reaction with relatively short dated options once the market has settled a bit and liquidity has returned.

Trading around the edges

Traders expecting a Brexit scenario may have a hard time finding deep, out of the money option scenarios – even in non-sterling pairs – that are attractive in risk/reward terms given that central banks might band together to open swap lines with the Bank of England and mute illiquidity risks in the event of a Brexit (as at least some European Central Bank sources have indicated). 

Nonetheless, the market can’t help reacting in some way and traders who still want to hedge the referendum may consider GBP-correlated, long-volatility options trades for the other side of the referendum vote.

Trading stance: Traders who are looking for a Bremain outcome but reluctant to pay the options premium for sterling options might consider EURCHF call spreads or call options for expiry in the week after the vote or slightly longer term. 

Traders maintaining high odds of a Brexit risk might consider EURUSD put option structures over a longer time frame of one or two months, which might actually pay off in either scenario in the medium term.

Forex traders may be champing at the bit to get in on the sterling action that is bound to surround the referendum, but those who play with fire often get burned. Photo: iStock 

— Edited by Michael McKenna

John J Hardy is head of FX strategy at Saxo Bank

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