What the Options Market may be saying about the Euro and Yen

The latest leg down for the euro began in mid-October when the single currency met a wall of sellers in front of $1.15.  Draghi's dovishness at the press conference following the October 22 ECB meeting sent the euro toward $1.11.  The contrasting hawkishness of the Federal Reserve, where the FOMC statement on October 28 specifically cited the next meeting, pushed the euro to $1.09.   The largest rise in US nonfarm payrolls this year saw the euro sell off through the $1.08 area which had offered support in the summer.   Many participants have their sights set on the multi-year low set in March near $1.0460, and parity. 

Even if one does not trade currency options, sometimes insight can be gleaned that help the price discovery process.    Very short-dated options that many observers focus on tracks spot too closely to be particularly useful for our purposes.   For this exercise, we look at three-month volatility and risk-reversals. 

Three-month implied euro volatility trended lower from early September (when it peaked near 11.65%)  through mid-October (when it hit about 9.13%).   Recall the euro was trading mostly between $1.11 and $1.14.   With many doubting a Fed hike at all in 2015, the net short speculative euro position in the CME futures fell to its lowest level since mid-2014. 

As the euro broke down, volatility has jumped.  The day before the US October jobs report was released, 3-month implied euro volatility reached 12%, the highest since the Greek anxiety in early July.   There seems to be a couple considerations at work.  First, by breaking below $1.08, the euro is at levels not seen in seven months.  That alone would seem to warrant high volatility. 

One might intuitive suspect that participants are buying euro puts, which would help account for the firmer vol.  However, the risk-reversals tell a somewhat different story.    Recall that put-call parity says that options equidistant from the forward strike should trade for the same price.  To the extent they do not, shows a market bias.  Three-month euro calls have not traded at a premium to puts since 2009. 

In late-June, as the debate over Greece threatened to spur a disintegration of EMU, euro calls for at nearly a 3% discount to puts.  As the euro recovered in the spot market from $1.08, the discount for euro calls was reduced to about 0.6% by late-July.  Through the China-induced spike in spot above $1.17 in late-August, the discount for euro calls tended to grow, rising to about 1.75% before the FOMC statement on October 28. 

However, since then, the discount for euro calls has been reduced.  It is currently quoted near -1.18, which is the smallest discount since the ECB meeting.  What is happening?  To reconcile the increase in volatility and the reduced euro call discount, it would seem investors are buying euro calls for insurance or a hedge on short euro exposure.   Sometimes the options market serves as a parallel market to spot.  Other times is functions more as an insurance market.  Currently the latter is prevailing. 

What about the yen?  The dollar was in a defined traded range against the yen from late-August through early-November, between JPY118.00 and almost JPY122.00.  Three-month implied volatility remained firm, above 10%, which was the upper end of the range from March through the first three weeks of August.  It then trended lower, hitting 8%, a three-month low in early November.  Volatility has firmed but remains relatively soft near 8.7%.  

While implied euro volatility is above its 50, 100, and 200-day moving average, implied yen vol is below similar moving average.  In the spot market, the dollar is above the same moving averages.    The subdued response to the break out in dollar-yen suggest many operators may not be exceptionally bearish the yen. 

Three-month dollar calls against the yen  were at a 1.4% discount to puts (equidistant from the money) in early September.  The discount turned into a premium in late-October and reached a high near 0.30% after the US employment data.  It has trended lower since.  The three-month dollar calls are again at a discount to puts (-0.20%). 

The general trend has been for dollar call discount to be reduced while volatility has eased.  Until the early part of last week, this would have been consistent with participants selling dollar puts.  In the futures market, the net short speculative position was dramatically unwound.  In the middle of August, speculators were net short more than 100k yen future contracts.  By the end of October, this had been reduced to only about 3640 contracts.   

The dollar posted lower highs and lower lows almost every session last week.  However, on the pullback the dollar held the 38.2% retracement of this month's gains and today, it is posting an outside up day.   Initially, the dollar fell through the pre-weekend low on safe haven idea.  It has since recovered fully to trade above last Friday's high.  A close above that high, near JPY123.00, is needed to confirm the positive technical signal.  Meanwhile the three-month risk-reversal is drifting lower.  It appears that new demand for dollar puts are being bought. Here too the options market insurance characteristic is stronger than its function as a parallel market. 

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