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Please be noted that the shrink in EURGBP implied volatility of ATM contracts 1m tenor and spike in 3m tenors.
While the risk reversals, for now, have taken adverse directions that were bidding for upside risks from last 1 year’s hedging sentiments. You can now make out intensified hedging sentiments for downside risks and this shift in OTC indications and IV movements would prompt us to strategize below hedging vehicles via options.
Fading IVs towards 12.7% 1m tenors, the tepid IVs among G10 FX space despite the fact Eurozone elections are lined up appear to be conducive for exorbitant call option writers as the delta risk reversals are bidding for puts progressively with negative numbers that signify hedging arrangements for downside risks over the period of time.
While the positively skewed IVs of ATM contracts are signifying the hedgers’ interests in OTM puts that are in sync with the risk reversal indications.
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 favor. If IV increases and you are holding an option, this is good.
On the flip side, when you write an option, the seller wants IV to remain lower level or to shrink so the premium also fades away.
Hence, considering above OTC market reasoning, we think downside risks are on the cards, as result we reckon deploying shorts in such exorbitant call options while initiating longs in ATM puts in our hedging strategies that seem worthwhile if you have to ponder over the payoff structure under the scenario of the underlying spot FX keeps dipping further.
