At a Glance
- Trading in longer-dated maturities may be on the rise now that the volatility environment has changed.
- Lower costs and flexibility around event risk seen as key elements of weekly options
There has been a marked change in volatility levels in the FX markets in recent weeks.
At the start of the year FX market volatility was approaching all-time lows. The widely viewed JP Morgan G7 FX volatility index was below 7 for most of 2019 and fell below 5 in January 2020. In comparison, the lowest value observed in 2016 was 9.12. However, in March the index topped 15, its highest level in over 8 years, coinciding with multiple central bank interest rate changes and concerns over U.S. dollar funding as a result of the coronavirus.
Source: Bloomberg LP
Backpedal to January. The Bank of England published its biannual survey of FX dealers from October 2019, which confirms a trend for foreign exchange options traders to increasingly trade shorter-dated maturities.
Across all currency pairs, the proportion of options with maturity of one month or less increased from 37.4% in October 2017 to 44.6% in October 2019.
Source: Bank Of England
So why was there a preference for shorter-dated options?
To answer that, let’s first review what traders are seeking in a short-dated contract. These options with non-traditional maturities allow market participants to hedge around short-term risk affixed to economic or geopolitical events. For example, a scheduled announcement from the Bank of Japan on a Tuesday could require short-term protection against a big move in the Japanese Yen. A trader might employ a strategy that includes short-dated options expiring on Wednesday.
Because participants are holding the option for a shorter time period than the traditional monthly, they are also a less expensive risk management solution.
In a low-volatility environment, there may be a trend towards fewer volatility-based strategies, which are strategies that benefit from changes in expected (implied) volatility. Volatility-based trades are a key element of any options market, but they tend to occur in longer dated maturities where options values are more sensitive to Vega (blue line).
When volatility falls over a longer period, the variability of volatility tends to fall as well. If volatility is itself less volatile, then the risk-reward ratios for trading vega-based strategies will be reduced, while tying up capital for longer periods, making longer dated strategies less attractive.
Perhaps a more significant feature of a low volatility environment is that option premiums are lower and thus, option time-decay or theta, often thought of as an option’s rent, is cheaper. Because an option’s time decay accelerates as the option nears its maturity (orange line), the combination of lower premium and higher sensitivity effectively increases the responsiveness and attractiveness of short-dated strategies for both sellers and buyers.
The sharp downtrend in volatility over through to January and its impact on option pricing behaviour may explain some of the switch to shorter-dated options trading observed by the Bank of England over that same period.
CME Group offers multiple short-dated option maturities across a range of FX currency pairs. Weekly options expiring on Wednesdays and Fridays across five currency pairs have been available for years, and options with Monday expiry have recently been launched.
This addition of weekly Monday maturities provides a tool for market participants to manage the potential price jumps or dips seen over the weekend and adds flexibility for participants’ growing focus on short-dated trading and hedging strategies.
Time Marches On
Where low volatility implies more trading in shorter dates, higher volatility should imply more trading in medium and longer dated options. We won’t see further data from the Bank of England or the other forex committees for a few months, but a review of CME Group’s recent option trading seems to confirm this theory.
There’s a natural monthly cycle to CME’s FX option product suite. In the month since the March 2020 expiry, over 30% of activity has been for expiries over two months out.
The intent of short-dated options in any market is to address the immediate needs of traders looking to hedge around a particular event. This remains true regardless of volatility levels and trading strategies. With a sudden risk can come an equally sudden need to protect positions.
We have seen this recently as global markets digest the news around the coronavirus and fears of an economic downturn. Of course, as the Bank of England report suggests, FX traders were moving to shorter-dated options before any recent news. The trend can be attributed to, among other things, a realization that more hedging tools exist to address the persistent challenges facing FX market participants.