Currency options showing possible Euro downside

Tuesday, 12 April 2011 10:28

Traders in the currency option market are still betting on downside in the euro verses the dollar, with risk reversals for short dated options still showing a solid bias for "puts" despite an 8.3 % rise in the Euro this year.

Normally, as the euro rises, risk reversals tend to turn neutral and later start exhibiting "calls," or bets that it will rise. This has not occurred and may indicate the options market is not sure the currency is headed north.

Market makers are being forced to buy downside euro/dollar risk reversals to balance their portfolios, having sold sizable strikes at lower levels in the euro that they need to hedge. At the other end, corporate hedgers have no desire to grab upside euro/dollar strikes either.

Data from the Commodity Futures Trading Commission showed euro net long positions totalled more than 59,000 contracts in the latest week, a one-month high. As the euro rises to extreme levels, however, the prospect of a pullback also increases, leading investors to hedge that risk.

Euro/dollar risk reversals in late Novemeber were at -2.73 vol, then on Tuesday, euro risk reversals traded at -1.35. But the negative skew has occurred at a time when implied volatility is low meaning a  -1.35 vol skew from a high of -2.73 was nothing to write home about.

Rate increases by the ECB could hurt fiscally weak peripheral nations such as Spain through higher bank funding and mortgage costs for the broader economy. some in the market think the divergence between the skew in risk reversals and the spot market may also be caused by the buildup of positive bets on the euro in the futures markets.