FxWirePro: Has Brexit dust settled down? Sterling tantrum on cards in H1’2018 – Diagonal straps for smart hedging

The pound has been especially sensitive to Brexit developments over the last few months. In December, the EU determined that ‘sufficient progress’ had been made on divorce-related matters - which included coming to a financial settlement in the region of £35-40bn, no hard border between Northern Ireland and the Republic of Ireland and agreeing on the rights of EU citizens – allowing discussions to move onto the nature of the future trading relationship.

Initial statements from Brexit Secretary Davis and EU Chief Negotiator Barnier have highlighted how negotiations could yet test the unity of both sides. Davis has suggested that the UK is aiming for a ‘Canada plus plus’ deal, adding that the intention through negotiations is to treat goods and services as ‘inseparable’.

However, Barnier has already outlined that there will be no ‘special’ treatment for the UK financial services sector.

Even with sterling making new lows in trade-weighted terms (nominal and real), we see only the GBPUSD meandering in a 1.30 - 1.35 range for most of 2018.

A fall to GBPUSD 1.20 would require, above all else, a stronger US dollar rather than a weaker pound alone.

We think the chances of a fall that far are about 5%, whereas, by contrast, the chances of the GBPUSD reaching 1.50 are around 15%, reflecting the possibility of another election being called and speculation emerging in earnest, that the UK could see a second Brexit referendum.

That is unlikely but not impossible and not definitely priced in by the FX market.

OTC outlook and options strategy:

Let’s glance on sensitivity tool, the positive shift in risks reversals that indicates the bullish risks in underlying spot FX prices.

Positively skewed IVs coupled with bearish neutral risk reversals of 6m tenors signifies the interests of OTM put strikes that means the ATM puts have the higher likelihood of expiring in-the-money, while balanced hedging sentiments on either side in 1m tenors that are favorable to both call and put options holders’ advantages.

Bearish neutral risk reversals indicate hedgers still bid for downside risks.

Hence, in order to arrest both upside risk that is lingering in intermediate trend and major declining trend, we recommend diagonal option strap strategy that favors underlying spot’s upside bias in short run and mitigates bearish risks in the medium term.

So, we recommend building the FX portfolio exposed to this pair with longs positions in 2 lots of 1M ATM 0.51 delta calls and 1 lot of ATM -0.49 delta puts of 6m expiries, these options positions construct smart hedging at net debit.

The strategy is likely to mitigate both bullish as well as bearish risks irrespective of spot moves. However, on speculative grounds, more potential is foreseen on the upside. Please note positive cashflows whether underlying spot keeps flying or dipping.

FxWirePro launches Absolute Return Managed Program. For more details, visit: 

http://www.fxwirepro.com/invest