FxWirePro: Dual strong thematic but defensive trade ideas in cross assets via variance swap spreads

We have suggested two cross-asset variance swap spread trades since the note, and there are important lessons that we have learned in a low-vol environment. As these trades are most likely to be used for carry in a low-vol environment, we have found that when going long the FX leg, it has been better to trade equal Vega on both legs, whereas a long position on the equity leg has been most profitable when sizing it according to the ratio of variances.

In the case of the EURGBP vs FTSE100 trade, we note that our recommended weighting for the FX leg was in the ratio of Vega, which we thought was a balance between being too aggressive (equal Vega) and too defensive (var weighted).

Variance swap spreads are creeping up in snail’s pace. In an environment where equity implied vols are trending lower all around, variance swap spreads have been tough to carry from a marked-to-market perspective, especially in the initial stages of the trade. We have preferred the pairs that rely on a strong thematic, rather than to only the classic statistical, approach. Brexit has been our favored theme, with two trade ideas.

We successively recommended a long UKX vs SPX Dec17 variance swap (in December 2016) and a long EURGBP vs FTSE100 Dec17 variance swap (in June 2017).

In the following two charts, we try to break up the marked-to-market P&L of the variance swap trades into the implied and the realized components. We notice that the bid-offer spread and implied trends have caused the initial P&L to look mediocre despite the realized trends being supportive. It’s only after the passage of some time that the weight of realized vol picks up and the trades start to look optically more profitable.