FxWirePro: FX Vol shrinking and need for theta control

A deficiency of alpha opportunities overall within FX universe away from the broad dollar outlook is also being blamed for a lack of leveraged investor enthusiasm for options. There is some merit to this argument in that substantial currency misalignment that had provided fodder for major macro trades earlier in the decade have shrunk to multi-year lows (refer above chart).

While that fact is undisputable on its own, it is still unsatisfactory as an explanation for the vol softness in recent weeks since the process of diminution of value opportunities has been in train for months if not years and FX vol itself does not seem to bear much of a correlation to the metric.

In short, our sense is that, market participants are as perplexed about exhausted FX vols as we are and that most of what is passing for explanations are little more than post facto rationalizations of price action. Market strategy amid this uncertainty is respectful of the need for theta control in this climate via a mix of carry trades in good quality EUR/EM crosses where carry/vol ratios are elevated (EURRUB) and RVs designed to earn hedged vol carry (EURCAD vs EURRUB, short NZD vs. JPY correlation via vanilla triangles).

Defensive trades held in the form of cross-yen vs. USD-vol spreads (GBPJPY – USDJPY, BRLJPY – USDBRL) have held in well so far, but standalone long forward vol lookalikes in EURGBP and USDCLP are proving challenging. Portfolio changes this week involve taking profits on a long-held EURCNH carry position in light of the escalation in trade war rhetoric, and adding a short 2M EURGBP – EURAUD correlation swap.

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