EUR: Still cheap to hedge euro vulnerabilities – SocGen
Olivier Korber, Research Analyst at Societe Generale, points out that the recent euro tumble triggered a large sell-off in the EUR/USD vol market and even though the short-dated skew did not turn negative, ensuring that out-of-the-money short-dated euro puts are still a cheap hedge against a deeper correction.
“The EUR/USD option market experienced a large sell-off after last week’s ECB dovish communication, which sent the euro tumbling. Both volatilities and risk reversals (RR) came under significant selling pressure, with the front-end of the implied vol curve back at its summer lows (the sub 3m segment is trading below 7) and short-dated RR trading at nearly flat levels.”
“Arguably, this move could be attributed to the vol market unwinding the long gamma positions that it has built up ahead of the ECB meeting. However, tactical positioning cannot fully justify such a sell-off, as 1) the fast euro move generated substantial realised volatility, and 2) one could expect the option market to be quite nervous with the spot testing its important horizontal support just above 1.16 (the upper bound of the 2015-2017 range).”
“Although the option market is now certainly much less confident that we should have imminent volatility on the topside (as reflected by the softest RR), market pricing has not yet switched towards substantial bearish risks. Despite the euro tumble, the RR did not dip back into negative territory and, notably, implied volatility preserved its positive correlation with the FX spot rate as both fell together. (Only the 6m RR is priced more negatively than the rest of the curve because this tenor includes the Italian election expected in early 2018).”
“All in all, the current situation is a fragile equilibrium, and the recent dynamics are making short-dated OTM euro puts still a cheap hedge against a deeper correction, as owning the puts could offer gains in terms of both spot direction and volatility.”