A Dow Jones CommentaryPlus Column
TRADE: Short USD/JPY 3-month to 1-year calendar from +0.15 vol, targeting fall toward 1-year mean of -0.71 vol or lower.
The dollar has been lethargic against the yen for some time, but the options market is starting to price in some turbulence after the Dubai debt crisis rattled global markets and dollar/yen slammed to its lowest in 14 years before bouncing.
Such action has made long USD/JPY volatility look interesting again as spot moves sent actual volatility spiking above 20% on an annualized basis. An attractive way to buy gamma here would be with a short calendar spread, buying front-dated vol against a short position on longer-dated options, positioning for the nearly flat volatility curve to invert in the weeks ahead.
The volatility implied by the price of USD/JPY three-month at-the-money forward options rose 3.95 vol points last week to 15.00% mid-market as investors rushed for protection in shorter-dated options, outpacing the 1.05-vol rise in one-year implied volatility, to 15.15%.
This 1.65-vol flattening in the calendar spread, to +0.15 vol, is already huge: only Tuesday the gap was at +2.00 vols, or a hefty 1.77 standard deviations above its one-year average. But there's still plenty of room for the curve to correct its recent extremely steep slope.
If the spot rate continues to whipsaw--hit by new worries over the safety of sovereign debt from the Middle East to Ireland, as well as confusing comments from Japan on the yen--the USD/JPY vol curve could again invert. During the crisis-ridden past 12 months, the curve has averaged -0.71 vol (one-year implied trading below the three-month), sagging to an extreme -9.00 vols in October 2008 in the wake of the Lehman Brothers bankruptcy.
Shorting the spread (buying the three-month vol and selling the one-year) would position for such an inversion while offering the investor the chance to get long gamma in front of widening USD/JPY spot ranges and to hold short vega as back-end traded vols sit at range resistance.
At the front end, traders would use heightened intraday volatility to aggressively trade the deltas on the long-vol leg of the trade. Five-day actual vol, measured hourly, has spiked to 21.40%, or 6.40 vols above the one-month implied, on the raucous spot moves. The dollar plunged to Y84.80 Friday, rebounding to Y87.45 in Asia Monday, according to EBS. It's now at Y86.10.
Also supporting long gamma: increasing vol of vol. This suggests that traders turn away from trying to exploit the persistent vol risk premium--the spread of implied over actual vols--and instead look at shorter-term directional vol trades.
One way to monetize this view is with a bet on rising three-month vol, looking to buy front-end vol on dips to play the potential for increased uncertainty into the end of the year, especially as financial markets ponder sovereign default risks.
By contrast, volatility at the back of the curve has remained in a broad range near 15%, refusing to participate in the selloff that previously pushed down the front dates. This suggests vega should also be slower to rise as markets adjust expectations regarding future volatility, inverting the vol curve.
Also note that the volatility generated by one-year spot moves, now 12.64%, has come in above 15% just 9% of the time since 1990. The 90th percentile one-year realized vol is 14.56%, or 0.59 vols below the current market-implied rate. In addition, the one-year implied has a range ceiling in place since March around 15.40%--there's the potential for an implied-vol downtrend off this level.
For traders looking for a further USD/JPY downtrend but one that is contained by expectations that Japan will resume yen-selling interventions for the first time since March 2004, Dow Jones CommentaryPlus Monday recommended yen-call spreads, buying at-the-money yen calls and funding the purchase by selling out-of-the-money yen calls. (Subscribers, see "FXO TRADING IDEA: JPY-Call Spreads For Modest USD/JPY Decline," published 0351 GMT.)
May The Force Be With You.
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