FxWirePro: 6m delta puts for APAC crosses, gamma positive and vega neutral strategies appear most conducive hedging vehicles for EUR/USD

You could wonder which trades might offer the best opportunity for hedging an extended appreciation of the US dollar over the next few months. Entering long volatility trades was one of the main themes highlighted in this write-up.

We look at our FX Options Quant Screener for picking two FX hedging options ideas that offer a good entry point for hedging a strengthening dollar scenario.  

We expect AUD/USD to decline through 2017 on skinnier rate differentials and a pull-back in commodity prices. Our Dec-17 target is 0.68, 7% below forwards. The combination of a more high conviction Fed cycle in 2017 and further RBA easing should see policy rate cross-over occur for the first time since the early 2000s. This will leave minimal carry support for AUD, which is particularly important given its vulnerability to a turn in China’s momentum or adverse developments in global trade.

Well, Antipodeans pairs (AUDUSD and NZDUSD vols) appear the cheapest among the G10 space, based on the relative-value analysis for ATM vols. As we can see from the below-left chart, Kiwi vol trades near one-year lows and is undervalued by 1.8 standard deviations against its model value (almost a vol point).

While volatility premia are currently wide in the G10 space, those on AUD and NZD are amongst the tightest.

Furthermore, we had seen in the previous chart that the Aussie and Kiwi are possibly overvalued in the spot market and, due to their high-beta, could undergo consistent drops in the event of extended USD appreciation in the next few months.

The 6m 25-delta puts on NZDUSD and AUDUSD appear to offer value based on the arguments above.  

Elsewhere, Euro area political and the US policy risks would be the immediate drivers of the euro. In the Euro area, our base case continues to be that traditional parties would prevail. Thus, the second hedge opportunity can be spotted by looking at the EURUSD vol curve. The vol presents a peculiar shape, downward sloping up to 3m and upward sloping from 3m on. The market prices in a higher vol for the 6m maturity due to the uncertainty related to the French election.

The long 6m/short 3m vol trade allows for cheapening the cost of the gamma positive long 3m vol trade. By reducing the notional of the 6m leg, the trade can be structured to be gamma positive and vega neutral.