FxWirePro: Activate USD/CAD Calendar Spreads On Luring Forward Vols

The recent WTI crude oil price has been dramatically plunging since the beginning of the year, having tumbled from $60 levels per barrel to the prevailing $11 per barrel, a decline of 80%.

Despite the record-setting sell-off in WTI this week, USDCAD volatility remains somewhat puzzlingly subdued, especially in mid-curve tenors. There can be little doubt about the directional implication of weak oil prices for the loonie: the macro FX team has flagged that the Canadian oil sector’s high costs and lack of flexibility renders the ongoing global supply price war almost existential for the industry, and compounds stresses on an already fragile BoP that justifies an active long USDCAD 

recommendation with a price target of 1.48 by 3Q’20. FX options appear barely perturbed by this state of affairs however, and CAD forward volatility screens as one of the cheapest anywhere in FX (refer 1st chart) having retraced the bulk of its COVID-19 related spike in mid-March. Even accounting for the fact that CAD has never historically been a high-beta currency, we still struggle to explain the placidity of CAD vol amid extraordinary developments in oil prices; possible culprits are existing short positioning in CAD and supply of risk-reversals to dealers from corporate or leveraged macro flow (USD call spreads etc.) that are keeping option books well supplied with vol as spot climbs. Whatever the reason, at current levels, we see little downside to buying CAD vol in mid curve expiries (6M) via forward vol constructs that roll up along an inverted curve (1M 9.6 vs. 1Y 7.7). 

Our preferred long CAD vol expression is a USD call/ CAD put one-touch calendar spread with premium rebate as a leveraged forward volatility play. The choice of direction (CAD puts) is self-explanatory; of greater interest is that one-touch calendars of CAD puts screen as some of the best static carry / premium candidates at current market (refer 2nd chart). -2M/+4M as well as -3M/+6M calendars are priced attractively at >4.5 max payout / cost and >100% (annualized) static carry even with notionals set at 100% rebate (underweighting the shorter tenor option to ensure that the full upfront premium is recouped should the one-touch strike be triggered). 3rd Chart demonstrates that such premium-rebate one-touch calendars have done a reasonable job of capturing trend strength in the dollar over the past few years, and in our view stands a decent chance of delivering once again in coming months through the more mature phase of CAD weakness. For macro portfolios, rebate calendars are a useful leveraged complement to cash (or simple vanilla option) USDCAD longs. If run in parallel and spot were to settle between current market and the one-touch strike, both the core cash position and the OT calendar benefit; should the one-touch barrier trigger in the event of sizeable run up in spot and the calendar returns zero P/L, the underlying cash position would still benefit handsomely. There is no cover of course against the bearish CAD view coming unstuck altogether.

Trade tips: Sell 2M 1.46 strike USD call/CAD put one-touch vs. Buy 4M 1.46 strike USD call/CAD put one-touch, 0.85:1.00 notionals @14/16.25% USD indicatively. Courtesy: JPM