FxWirePro: Deploy collar spreads to hedge EUR/JPY, bearish-neutral risk reversals, shrinking IVs and skews to bid call on short leg and put on long leg

The nutshell showing delta risk reversal of EURJPY explains that hedgers’ interests have been bearish-neutral but downside risks are still lingering, however, no new shift in sentiments is observed both in short and long run. As a result, we don’t see much traction OTM calls.

You could observe that in EURJPY IV skews as well which has been showing mounting hedging interests in OTM put strikes in 1-month tenors, while 2w tenors show little upside traction.

In the recent times, EUR vols skews destabilized too much especially on post-French election results, while JPY volatility market normalized sharply. The liquidity recovered and the extreme positioning was ultimately absorbed. The price action is not taking the direction of an imminent new trend. As a result, the options market aggressively unwound smile positions.

Contemplating major downtrend and short-term upswings, anyone who wishes to carry long EURJPY exposures, a collar options trading strategy is recommended. This could be constructed by holding the total number of units of the underlying spot FX while simultaneously buying a protective put and shorting call option against that holding. The puts and the calls are both OTM options having the same expiration month and must be equal in the number of contracts.

Execution: Underlying spot exposure + short 2w (1%) OTM call + long 1m ATM put.

The collar is a good strategy to use if the options trader is writing covered calls to earn premiums on shrinking IVs (see 2w IVs in above nutshell) but wish to protect himself from an unexpected sharp drop in the price of the underlying spot FX via long leg in put bidding 1m risk reversals.