FxWirePro: AUD/USD IV skews and bearish neutral risk reversals – Use Vega longs in Put Ratio Back Spreads as optimized hedging vehicles

Bearish scenarios of AUDUSD below 0.73 given:

1) The unemployment rate moves back towards 6%, forcing the RBA to respond more aggressively to weak inflation;

2) The Fed responds to firm labor market outcomes and above trend growth by delivering a faster pace of hikes than currently expected;

3) China data weakens materially.

OTC outlook and Options Strategy:

Please be noted that the positively skewed IVs of 1m tenors signify the hedgers’ interests to bid OTM put strikes upto 0.7775 levels (refer above diagram).

While bearish neutral delta risk reversal divulges the interests in hedging activities for downside risks remains intact amid mild upswings.

Well, the bearish stance has been substantiated by AUDUSD's rising IV in 1-3m which is an opportunity for put longs in long term and using shrinking IVs of shorter tenors with bearish neutral delta risk reversal can be interpreted as an opportunity for writing OTM puts or Theta shorts in short run as the spot FX market reckons the price has downside potential for large movement in the days to come which is resulting option holders’ on competitive advantage.

Accordingly, we had advocated put ratio back spreads a couple of days ago, wherein short leg is functioning as the underlying spot FX keeps spiking.

So, the speculators and hedgers for bearish risks are advised to capitalize on the prevailing rallies and bid on 1-3m risks reversals to optimally utilize Vega longs.

We advocate weighing up above aspects and uphold the same option strategy on hedging grounds, we eye on loading up with fresh Vega longs for long term hedging, more number of longs comprising of ATM instruments and ITM shorts in short term would optimize the strategy.

So, the execution of hedging positions goes this way:

Short 2w (1%) OTM put option as the underlying spot likely to go either sideways or spike mildly, simultaneously, go long in 2 lots of Vega long in 2m ATM -0.49 delta put options.

A move towards the ATM territory increases the Vega, Gamma, and Delta which boosts premium. However, Theta (time decay) also increases especially as expiry approaches. Hence, OTM shorts in calls in such scenario are most suitable for speculation.