FxWirePro: NZD/JPY option hedging formula - Aggressive bears prefer vanilla puts and risk averse hedgers rely on debit put spreads

NZD underperformed, despite a modest upside surprise from the GDT dairy auction, slipping from 0.6902 to 0.6863 against USD, and partly retracing to 0.6894. AUD/NZD rose from 1.0746 to 1.0800.

The RBNZ has signaled the next cycle – a tightening one – will not start until late 2019. That will anchor the short end, although markets will not abandon their expectations for tightening as early as mid-2018 which means occasional spikes in the 2yr will be likely. The long end will continue to follow mainly US yields, which we expect to rise. That means the curve steepening trend should continue. 

OTC Outlook

ATM IVs of NZDJPY is trading between 7 and 9% for 1 and 2m tenors respectively.

Please also be noted that the options with a higher IV cost more which is why in this case OTM puts have been preferred over ATM instruments. This is intuitive due to the higher likelihood of the market ‘swinging’ in your favour. If IV increases and you are holding an option, this is good. When you write an option, the seller wants IV to remain lower level or to shrink so the premium also fades away.

Option Strategy:

Thus, conservative hedgers can prefer the below strategy:

Debit Put Spread = Go long 2M ATM -0.49 delta Put + Short 1m (1%) OTM Put with lower Strike Price with net delta should be at -0.40.

For a net debit bear put spread reduces the cost of trade by the premium collected (on the shorts of OTM put) and keeps option trader to participate in downward moves and any upswings in abrupt.

Moreover, the risk is capped to the extent of initial premium paid, as opposed to unlimited risk when short selling the underlying outright.

However, put options have a limited lifespan. If the underlying FX price does not move below the strike price before the option expiration date, the put option will expire worthless.

Alternatively, aggressive bears can bid NZDJPY 1m2m IVs & RR and buy 75 NZDJPY OTM put of mid-month tenors, sell a 1m in premium-rebate notionals.