FxWirePro: AUD/USD’s bearish neutral risk reversals and IV skews encourage ‘Debit Put Spreads’

Is the Reserve Bank of Australia (RBA) taking a break after two rate cuts in a row, or does it see the need for further easing? Market participants are likely to be hoping for decisive indications on this issue from the labor market report tonight.

The report provides higher-frequency insights into underlying price pressures, as inflation data are only published quarterly in Australia. The RBA is relying on the labor market to narrow further, which should sooner or later push up prices through higher wages. A renewed rise in the unemployment rate, as in the spring, will intensify speculation that the RBA could soon turn the interest rate screw again, which would put a damper on the AUD.

However, in light of recent good news from China, we expect the RBA to wait and see for now and we, therefore, feel quite comfortable with AUDUSD levels above 0.70.

We will now quickly run you through OTC outlook of AUDUSD, before proceeding further into the options strategic framework.

Please be noted that the positively skewed IVs of 3m tenors still signify the hedgers’ interests to bid OTM put strikes up to 0.68 level which is still in line with the above bearish trend (refer 1st nutshell).

Please also be noted that the minor positive shift in risk reversals (RRs) of the shorter tenors and bearish RRs of the longer tenors that are also in sync with the bearish scenarios refer 2nd (RR) nutshell.

In a nutshell, AUD OTC hedgers’ sentiments substantiate that their risk mitigating activities for the downside risks have been clear.

Accordingly, diagonal put spreads are advocated to mitigate the downside risks with a reduced cost of trading.

The execution of options strategy: Short 2w (1%) OTM put option with positive theta (position seems good even if the underlying spot goes either sideways or spikes mildly), simultaneously, add long in 2 lots of delta long in 3m (1%) ITM -0.79 delta put options. 

The rationale: Contemplating all the above factors, we have advocated delta long puts for the long term on hedging grounds, comprising of more number of ITM long instruments and theta shorts with narrowed tenors for 1m lower IVs to optimize the strategy.

Bearish outlook with rising volatility good for the option holder. 

While put writers would be on the upper hand on theta shorts in OTM put options that would go worthless on lower IVs as the underlying spot FX keeps rising, thereby, the premiums received from this leg would be sure profit.

We keep reiterating that the deep in the money put option with a very strong delta will move in tandem with the underlying. Courtesy: Sentrix and Saxobank