EUR/USD volatility calendar spread

We have been hearing a lot about green shoots these days and equity markets have completed a remarkably strong six-month run but we could be getting ahead of ourselves. We aren’t officially out of this recession and when the economy does emerge it will be due more to government intervention than legitimate economic growth. As we hit the one-year anniversary of the ground zero moment of the current economic crisis, what would be a solid forex strategy for those of us who see more rough waters ahead?

A EUR/USD volatility calendar spread is one way traders can take advantage of possible increased market volatility this fall. Consider purchasing a near-term at-the-money euro straddle struck (– 1.4300 on Sept. 1,) vs. selling a one-year at-the-money euro straddle (– 1.4295 on Sept. 1). We are looking at the October 09/10 at-the-money straddle spread.

This trade can either be put on delta neutral with four equal notional legs, or the trade can be put established vega neutral with a weighting of 3.44/1 on the near-term straddle.

The chart below displays the one-year historical spread analysis between one-month euro volatility and one-year euro volatility. As is noted on the upper right hand side of the chart, the one-year mean differential in the spread over the past year was -1.4348. Further examination of the spread summary section shows the high and low over the course of the past year. One-year volatility was lower than one-month volatility at one point in October 2008 (-10.67) when the financial industry was at its peak meltdown stage. The other end of the range is very close to where we are currently trading, +2.2675, with the current trading level at +2.0300. Dropping down below the spread summary section there is a graphical sideways, bell-shaped curve which illustrates total occurrences and where we currently stand relative to the mean represented by the mid-point of the bell-shaped curve. The current entry point to this trade looks attractive historically at +2.0300.

Taking a look at the fundamental side, the current volatility curve shape in the euro denotes a sense of complacency in the market. One would expect one-month volatility to trade below one-year volatility when a currency is holding in a range and economic conditions are stable and predictable in the near term. Indeed, market sentiment has turned positive with a slew of upbeat economic releases and rejuvenated global equity markets.

This trade strategy offers a great entry point for market participants who feel the current positive sentiment is premature. If we see additional financial industry turmoil, namely regional bank failures due to deteriorating commercial loan portfolios, current economic sentiment could quickly sour. Furthermore, the consumer remains highly leveraged and banks are not lending. Without consumers having the ability to leverage themselves, one could make a convincing argument that we are seeing unsustainable global equity valuations.

In a Greeks analysis of this trade, assuming $1 million euro per leg, a one-month at-the-money-forward (ATMF) straddle has an ATMF strike of 1.4523, the cost of straddle is $3,697.50. The expiry date is Oct. 9, 2009 and the delivery date is Oct. 13, 2009. The delta hedge is buy $1,888/ sell €1,300. The gamma position is long $36,300, and the vega position is long $337.57. The time decay per day is $60.08. Volatility is 10.95.

For a one-year at-the-money-forward (ATMF) straddle, the ATMF strike is 1.4529. Premium received is $14,815. The expiry date is Oct. 8, 2010 and the delivery date is Oct. 10, 2010. The delta hedge is sell $7,406.73/ buy €5,100. The gamma position is short $8,850 and the vega position is short $1,140. Time decay per day is $19.68 and volatility is 12.98.

For a net combined position (long one-month straddle/short one-year straddle ATMF), the ATMF strike is long 1.4523/1.4529. Net premium received is $11,117.50. The delta hedge is sell $5,518.64/buy €3,800. The net gamma position is long $27,450 and the net vega position is short $802.43. Net time decay per day is $40.40. The volatility differential is 2.03.

As you can see, the above spread is structured relatively delta neutral, leaving the trade net long gamma/short vega position. Also, the trade has a net cost of $40 per day if spot does nothing. The trade will perform well if market volatility picks up in September after a rangy 1.40-1.45 range trade throughout July and August. If the market makes a sustained break above 1.4500 and trades towards 1.5000, the one-month volatility should increase and eventually trade back above one-year volatility.

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