FxWirePro: A Glance at Risk-off Digital Options For Vega Exposure

The US-China trade developments remain very fluid and we are bound to see a few more adverse episodes.

The Cheap vega ownership could be deployed in anticipation of the vega tenors receiving more attention with the spot now under the watchful PBoC hand, we recommend using the favorable vol entry levels to add vega.

Risk-off digitals: Last week we looked into risk-off digitals for the USD pairs. Here we expand the analysis to crosses. 2nd chart ranks the currencies on a risk/reward metrics based on: 

i) The available spot retracement room, and 

ii) The spot-to-strike distance of a 3M 5:1 geared at expiry digital option in the direction of the anticipated spot moves. Digital options most closely mimic call and put spreads, which are frequently used by global macro investors to express directional views, but digitals come with the analytical advantage of a single strike and apples-to-apples comparability across pairs for an arbitrary ex-ante gearing. 

The spot retracement room we estimate as the peak-to-trough sell-off of the underlying during April/May, less the decline from the local July peak to current levels already witnessed. Greater the headroom for spot relative to the threshold move required to deliver the maximum option payout, better value the option. 

Turns out that the CHF-x currencies sell-off in July/August has already exceeded (or left virtually no headroom for spot) the April / May peak-to-trough decline thus we don’t include them in 1st chart which ranks the remaining JPY-x based on the risk/reward metrics. 

On this metric, JPY/KRW and AUD/JPY call (put) spreads / digitals screen as the cleanest crosses to hedge against broad-based weakness. 

While TRY/JPY tops the list by virtue of it having been much less reactive so far, which could change if lira’s monetary easing starts to weigh.  Courtesy: JPM