FxWirePro: “Counter-cyclical factor, one-off devaluation” lead to tepid vols in USD/CNH - “Strangle shorts” to fetch certain yields

With extremely low volatility and expectations of a stable USDCNH, the market prefers the carry trade again. Taking one-year tenor as an example, the implied yields of CNH is above 4%. In other words, as long as USDCNH remains stable, a trader can get a decent positive carry.

Of course, the risk of such carry trade is a significant depreciation of CNH against USD. This happened a few times in history, and the most impressive one was the “one-off devaluation” in August 2015. In our opinion, the popularity of carry trade also reflects China’s rigid FX regime.

After the introduction of “counter-cyclical factor” in the fixing mechanism, the market has to accept the fact that the “invisible hand” has become more powerful. In other words, only this hand can make the market to become volatile again. Probably, the next move will be another “one-off”.

Clearly, this kind of “unknown-unknowns” can’t be priced by the financial derivative instruments, such as FX option, which means that the market continues to expect a stable USDCNH. Therefore, an FX trader can, on one hand, obtain the positive carry, but on the other hand hedge in the FX options market at a low cost (due to low volatility).

As a result, we recommend below option strategies using right options, thereby, one can benefit from certain returns.

Naked Strangle Shorting:

Short 1W OTM put (1.5% strike difference referring lower cap) and short OTM call simultaneously of the same expiry (1% strike referring upper cap) (we reiterate, preferably short term for maturity is desired).

Overview: Slightly bearish in short term but sideways in the medium term.

Timeframe:  7 to 10 days

Alternatively, one can also prefer iron condor on the same lower IV circumstances. To execute the strategy, the options trader buys a lower strike OTM put, sells a middle strike ATM put, sells a middle strike at-the-money call and buys another higher strike OTM call. This results in a net credit to put on the trade.