FXO Market Update - Sep 22

USDJPY continue to trade lower after the break of 105.00 last week. Spot touched 104 yesterday before retracing back up to current levels around 104.50.

Vols continues to trade higher and 1 month traded above 7.0 when spot was down at 104.00 yesterday. We open a touch lower today as spot has moved away from the lows, 1 month currently trades around 6.85, while it traded at 5.85 before the break of 105.00 last week. Risk reversals trades relative stable with 1 month at 1.25 for puts.

The curve trades very steep like all USD pairs due to the US election in November. 2 months tenor, which covers the election, trades significantly higher then the front end of the curve. 2 months trades at 9.4, 2.55 vol above the 1 month.

Market is long gamma on the downside from barriers, where the main bulk of gamma comes from barriers in the 103-101 area. Barrier options gives the market a lot of gamma when spot trades close to the barrier, especially when close to expiry. The option ceases to exist when the barrier gets hit and the supply of long gamma disappear. The barriers will add extra support to spot when moving lower as the market makers must hedge the gamma by buying spot on any move lower in spot.

We will take a look at a couple of different strategies which benefit from a move lower in spot and looking at the 3 months tenor as most strategies are short vega and the 3 month offer significantly higher vol than the 1 month or shorter. Also, when looking at the barrier options we want to have the barrier below 101.00. Buying too short barrier option would not offer enough discount to the equivalent vanilla when adding barriers below 101.00

Vanilla put option
Buy 3 months 104.00 USDJPY put
Cost 170 pips

Ratio put spread
Buy 3 months 104.00 USDJPY put in 1 mio
Sell 3 months 100.00 USDJPY put in 1.5 mio
Cost 76 pips

Put Fly
Buy 3 months 104.00 USDJPY put in 1 mio
Sell 3 months 100.00 USDJPY put in 2 mio
Buy 3 months 96.00 USDJPY put in 1 mio
Cost 72 pips

Reverse Kock-Out
Buy 3 months 104.00 USDPY put with RKO 100.00
Cost 21 pips

Reverse Knock-Out
Buy 3 months 104.00 USDJPY put with RKO 99.00
Cost 32 pips

Spot ref. 104.60

The ratio put spread is the only strategy that offers risk on the downside as you are selling more of the 100.00 put. This ratio offers a good reduction of the total premium, total cost less than 50% of 104.00 put, and breakeven is as far down as 92.72.

The put fly offer same pay-out profile as the ratio put spread down to 100.00 while it is a bit worse off between 100.00 and 96.00 as it has a higher ratio of the 100.00 strike. On the other hand it has no risk to the downside as the bought 96 strike cut any potential losses, except the premium paid, and it cost a touch less than the ratio put spread.

The RKO options offer great discount to the vanilla where the 104.00 put with 100.00 knock-out cost only 12% of the vanilla. Downside is that the option gets knocked out if spot trades down at 100.00 before expiry.