In view of some fairly substantial economic events during the first three months of 2016, it’s logical to wonder what has happened to the volatility measures of major currencies. “Volatilities compared: Currencies vs. crude oil” (below) shows a surprising gap between six currencies that are going quietly toward zero while crude oil continues at approximately four times the volatility measures of the usual suspects such as the Swiss franc and Japanese yen.
The clustering of currency options is also something new. As shown by “Calls on June and December futures” (below), the franc, pound, euro and Australian dollar are tightly grouped at both expiration dates. The September expiration (omitted from this chart to avoid overcrowding) exhibits a similar closeness between the four options. In the June and December calls analyzed on March 10, one interesting shift is the British pound moving from a low volatility for June to one of the highest in December. This might imply undervaluation of pound calls for June or overvaluation for December, with a potential trade based on a return to normal pricing.
Following this paragraph, this article lists volatility measures for six currencies and for crude oil), and four currencies for the June and December expirations. The volatility measures are call prices as a percentage of the strike price where the futures price equals the strike price.
The following are volatility values on June calls (as of March 10, 2016):
Crude oil: 8.11
Canadian dollar: 2.11
Japanese yen: 2.23
Swiss franc: 2.04
Australian dollar: 2.52
British pound: 2.17
These are volatility figures on June, September and December futures (as of March 4, 2016):
June Sept Dec
Swiss franc 2.07 3.39 4.07
British pound 2.09 3.93 4.42
Euro 2.27 3.37 4.04
Australian dollar 2.60 3.96 4.64
Having low volatility measures does not eliminate the potential for options trades on a single futures contract between strike prices. These trades depend on the accuracy of pricing along the options price curve. For example, on “British pound call options” (below) there are variations from the predicted price curve for most strike prices. On March 4, 2016, the closing prices for June and September futures included several variations from the predicted values that suggested trading potential. At strike 1.440, the variation from predicted was minus $155 for June, and at strike 1.450 the call price was $229 less than predicted for the September expiration.
The predicted prices are computed as a logarithmic parabolic curve that essentially matches the Black-Scholes options pricing model from far out-of-the-money calls to the point at which the underlying price equals the strike price. For strike prices 1.610 through 1.510, it is likely that few options were traded, so the closing prices are equal to, or close to, the computed values. This semi-artificial pricing is true for most of the December calls, and the reason, again, is lack of actual trading. Where trading is active, there are larger variations from the predicted values. For the June and September expirations, market-driven variations are noted for strikes 1.500 through 1.430 and delta values 0.130 to 0.585.
Trading price variations
Success in trading price variations depends on speed in finding strike prices where differences exist and then completing a trade at or near the price listed. Computers that continuously scan the options market for pricing opportunities would have an advantage, mimicking the price variations shown by the closing prices shown in this article.
On all options price curves, the smallest variations from predicted value range from zero to less than $10, which is impressive accuracy because the value of an options price point is high — for example, on British pound options it’s $62,500 per point, and for the yen it’s $125,000.
How much variation is needed to result in a profitable trade? For a market-maker’s cost-free trading, not much at all. The market is responsive to automated trading based on pricing models like the one behind the analysis of British pound calls. The disturbance — with larger variations — results when actual trades take place at prices some distance from the predicted values; however, theoretically correct pricing is stronger than individual ideas of valuation and the predicted price curve is the usual winner.
A trader on March 4 might have bought one September 2016 1.450 strike at $2,187.50 and sold short one 1.460 strike at $2,193.75. The opportunity is to place one strike price against another to avoid betting on a price change of the underlying, although the reason for the trade is an error in valuation of one or more option. On March 10, the 1.450 strike closed at $2.858.75, while the 1.460 was $2,550. The loss of $356.25 on the 1.460 strike reduced the gain of $671.25 on the 1.450 strike for a net profit of $315, which is approximating the $229 undervaluation and assisting in the arbitrage process.
In a similar spread trade using June futures, on March 4 the 1.440 strike was bought for $1,125 and two 1.480 strikes were sold for $562.50 each for a total of $1,125. On March 10, the 1.440 strike was $1,487.50 and the 1.480 strike was $625. The closing prices produced a gain of $362.50 for the 1.440 strike. The 1.480 strike closed on March 10 at $625, or $1,250 for the total repurchase and a loss of $125. This spread had a net gain of $237. As shown above, working with adjacent strike prices should permit credit spreads in many instances, with the sold strike exceeding the cost of the purchased call. Gains are expected to be small, but there should be multiple opportunities in each day’s trading.
The LLP pricing model for “British pound call options” indicates upper and lower breakeven prices for each strike price. These are the prices at expiration that will result in a zero gain or loss on a delta-neutral spread, selling the number of calls equal to 1/delta and taking a long position in the underlying futures or stock. For example, selling 1/0.472 or approximately two of the 1.440 calls at $1,125 (a total of $2,250) hedged by a long June 2016 futures contract at 1.423 should result in a breakeven trade at expiration of the futures price on that date is either 1.489 or 1.385. A profit will result if the futures price at expiration is between the breakeven prices. However, if the closing futures price is above or below the breakeven spread the ultimate loss is unlimited.
The breakeven price spread may be used to form long strangle and short strangle trades. For a long strangle, a put and call are bought within the breakeven price range with the assumption that between the current date and expiration the futures price will vary enough to make the put or call, or perhaps both the put and call, profitable. The charts in “Currency strangles” (below) show strike prices and purchase prices for each put and call in addition to the underlying futures price.
An alternate use for breakeven prices is the short strangle in which a call and put are sold short outside of the breakeven range. The trader counts on the futures price not exceeding the strike price of the short call before expiration or falling below the strike price of the short put. Unlike the long strangle, in which risk is limited to the purchase price of a call and put, the risk is unlimited in the short strangle in the absence of risk management trades.
Volatility plays a significant role in the strangle trades. In the long strangle, the trader wants high volatility to carry the put or call price (or both if he is fortunate) to low or high levels for the maximum profit. For the short strangle the opposite is true, with high volatility being a disadvantage — associated with potentially unlimited risk.
Considering the market’s current opinion related to low volatilities for the six currencies shown, this may be a good time for short strangles. On “Currency strangles,” there are 12 trades described on March 11, with a short strangle and long strangle for each of six currencies. The expiration date in June 2016 is a little less than 90 days in the future. We can follow these potential trades to see:
1) the profit and loss scores at or near the expiration date for each strangle, and
2) whether the market is correct in assigning low volatility values to currencies.