By many accounts, 2022 has been a year where we have reverted to some old styles, some old norms, some old concerns, and some old price levels. We have seen a revival of psychedelic stripes and Bohemian chic fashion. We have soaring gasoline prices and shortages in many parts of the world. We may be reverting to a new geopolitical order that resembles times before the fall of the Berlin Wall. Many economists point to the inflation levels that we haven’t seen since the 1970s. Even in financial markets we are seeing some reversion to levels that we have not seen for many years.

The EUR/USD spot market has been in a declining trend since the Great Financial Crisis. Prior to 2008, with the U.S. housing market in shambles, there were many that thought it was the end of dollar hegemony. In 2007, there were dollar warnings from the likes of Warren Buffett and Bill Gates. Even Gisele Bundchen demanded to get paid in Euros and not dollars. The EUR/USD hit a high of 1.60.  It has been a different story since that time. Perhaps it was because the U.S. acted more quickly than Europe to refinance the banking system. Maybe it was the emergence and strength of the U.S. technology stocks. Possibly there is some other rationale for why it has occurred but since that peak, the EUR/USD spot has seen a series of lower highs and lower lows. As you can see in Figure 1, the market did get down to the 1.05 level back in 2015-2017 and held. This time around, we are hearing many of the same ideas thrown out as then. For example, will EUR/USD breach ‘parity,’ a level we have not seen since 2002?

It appears there are two issues weighing on the EUR relative to the USD right now. The first is the soaring prices of food and energy, which admittedly are hitting both areas, but are hitting Europe harder than in the U.S. because its primary source of energy has been more disrupted. The other issue has been that the Federal Reserve has been hiking rates sooner than the European Central Bank (ECB) and the expectation has been that it would continue to be more aggressive. Therefore, on both a relative economic outlook and an interest rate differential viewpoint, the USD has been favored relative to the EUR. Perhaps this could be changing. Recently, several members of the ECB have suggested that the ECB should begin raising rates and should begin with a 50-basis point hike. As Cameron Crise of Bloomberg Macro Man points out in a May 24 editorial, post these comments, there has been a very rapid pricing of rate hikes into the short-term interest rate futures curve in Europe. There have already been hikes priced into the U.S. STIR curve, but in fact over the near term, there are now more hikes priced into the Euribor curve than the Eurodollar curve.

Of course, nothing is set in stone for either of these markets. In fact, each central bank has a very different reaction function. The ECB has a single mandate and that is price stability. Up until now, in the face of very high inflation, it has chosen to look at high prices as a tax on consumers and expected prices to come lower. As prices have not stabilized, the ECB is poised to act. On the other hand, the Federal Reserve has a dual mandate. It also has a price stability mandate but has a full employment mandate, too. As a result, it must worry about growth and inflation. With layoff announcements from many technology and retail firms, rising jobless claims and now falling inflation expectations, the aggressive rate hikes priced into the Eurodollar market are now being questioned by some in the market. This hasn’t changed the pricing in the market yet, but there is more of a debate among participants than there was before. Remember, markets move at the margin, and right now, perhaps the ECB expectations relative to the FOMC expectations are beginning to switch.

There is a good amount of uncertainty on all fronts. Market practitioners have been tested on their ideas in all asset classes this year. There is no reason FX shouldn’t be the same. A month or two ago it seemed to be a very strong consensus that the dollar would continue to strengthen against all currencies, but notably against its fellow reserve currencies EUR and JPY. Markets don’t like uncertainty and respond by taking implied volatility higher. You can see from the QuikStrike graph in Figure 3, G5 FX vol has moved higher all year long and EUR/USD volatility has not only moved with it but has mostly driven the move. Despite the potential difference of opinions on the future direction and magnitude of central bank policy, we see that this level of volatility has come off the highs of the year, but still looks high relative to the last two years.

Only a couple months ago, with futures still around 1.10, there was a considerable demand for EUR/USD downside protection. Puts outright, puts relative to ATM, digitals and risk reversals were all the rage. We can see from the graph in Figure 4, the July time frame 25 delta risk reversal hit a high of 3.5 vols back in late February and early March. This level has now come down to under 1 vol right now, which is near the low of the year even if quite high by historical standards.

From this graph, you can also see the 25 delta risk reversal spike as futures moved lower and implied volatility moved higher. In fact, at this point, there is a clear correlation between spot and volatility, with lower levels of spot/futures expected to bring higher levels of implied volatility and vice versa. This isn’t just a 2022 phenomenon either, as we can see the two year correlation of EUR/USD spot and three month implied volatility comes in at -0.53. The current level of spot/vol (red star on the graph in Figure 5) does not appear to be too far from the fitted regression line.

What does this all mean for possible trade examples? More so than many other markets, I have always felt that FX was much more of a two-sided market, with participants that could and did actively take either side of a trade. This isn’t as common in stocks as investors are either primarily bullish or primarily bearish. In bond markets, you also have investors who are either perpetually biased toward lower rates or higher rates. Even in Ags, you have end-user preferences toward one outcome over another. FX is a different animal. Since FX is a relative value trade by nature, there are changing perceptions of this relative value, especially when looking among the reserve currency pairs. We have upcoming catalysts with both central banks as the ECB is meeting next on June 9 and the FOMC is meeting next on June 15 So, let’s consider the facts or information as laid out and consider two different examples – one upside and one downside – that could be implemented given the market pricing we see in EUR/USD right now and given the potential catalysts.

Back in 1995, I was working in the FX markets at a money center bank. We had a customer that did what I think was maybe the best trade I had ever seen in my career. To put this in perspective, we had just seen George Soros famously break the Bank of England. However, while in many ways that generated big profits, it was more brute force. This trade was more nuanced and skillful in my mind (and generated big profits). The trade was put on when USD/JPY was near 80 and expected to continue to move lower. The client took advantage of a one year forward, which priced a lower level of USD/JPY and sold an ATM USD put/JPY call using these proceeds to buy 5x as many upside USD call/JPY puts. It was done in big size (think billions not millions) and literally called the bottom of the spot market, something that even the U.S. Treasury couldn’t do at that time.

The set up for this trade considers that the skew in EUR/USD has not entirely been a function of the demand for puts. As you can see from Figure 6, the 25 delta puts have traded at a premium to the 50 delta puts and have been a driving force for the risk reversal price, going to 2.5 vols when the risk reversal was 3.5 vols (orange line). However, at that same time, the 25 delta calls were trading 1 vol below the 50 delta calls (blue line). Both lines have converged but the OTM puts still trade at a premium and the OTM calls still trade at a discount.

I also want to consider the term structure of volatility. For this example I will be buying options on net, so I want to find a part of the curve that includes the catalysts but also trades at the lowest relative point. The implied volatility on September options trade at a discount to the months around it. In addition, this contract will get the next three ECB meetings and two more FOMC meetings.

I admit, this idea is not for the faint of heart. Fortune favors the brave, as Matt Damon told us in the 2021 Super Bowl ads. It is a ratio risk reversal idea akin to the idea of my client back in 1995. I look to the September contract to construct a zero-cost ratio risk reversal.  I sell one contract of the 1.07 EUR put. This is ATM spot and is relying on the 1.05 level that held back in 2015-2017 as well as this year to continue to hold (initial spot graph). I use the proceeds of that option to buy four of the 1.1350 EUR call. You may think this level is quite unobtainable, however, we started the year at 1.1370. If the views around relative central bank policy and interest rate differentials are really changing, does this seem as unachievable as it might have been one or two months ago?

I am getting a small vol premium on this trade and it is premium neutral. Of course, it is very long delta, long gamma, and long vega. But because of the initial cost, my theta is de minimis right now. The QuikStrike expected return chart is shown in Figure 8.  You can see that the payout is quite levered to the upside. However, there is risk to this trade as the delta of the trade is 1.0 at inception. Thus, a trader should consider this type of idea as a replacement for buying spot or futures. If a trader is of the view that the market is at and has seen the lows of the year in EUR/USD and wants to buy futures, this could be a better way to express that long idea, particularly if one feels that when sentiment flips, it could flip quite rapidly.

Consensus may still be quite bearish EUR/USD. However, consensus is not always wrong. Sometimes things play out exactly as we think.  Yes, there is the possibility that interest rate differentials will no longer widen in favor of the USD vis-a-vis EUR. However, some traders understand that it isn’t only interest rate differentials that drive FX rates. Capital goes to where it is treated best. Since the end of the Great Financial Crisis, this has been to the U.S. relative to Europe. Thus, there may be some traders that want to find a way to express a bearish view on the EUR/USD exchange rate.

In Figure 3, I showed that while EUR/USD implied volatility is high relative to the last few years, it has come well off the highs. Arguably, with so much uncertainty still in the market, it isn’t surprising, implied volatility is elevated. If we look at the CVOL charts, we can see that on a six month basis, EUR/USD volatility is near the middle of its range while other FX pairs are near their highest levels. In addition, in absolute terms of a 9.3 CVOL vs. other FX pairs that are mostly double-digit levels, EUR/USD looks like a reasonable value.

Though we all know that price is what you pay, while value is what you get. What you get in this case is the actual volatility. A buyer of implied volatility wants to make sure that actual volatility is as high or is higher. Looking at the QuikVol History, we can see that the implied volatility out to July is below that of the actual volatility, which is the highest it has been in a year. A buyer of volatility would be buying one of the lower implied volatilities in G7, which is well below the 20-day actual volatility, and in the middle of its range of the last six months. We can never forecast the future, but this provides an arguably better margin of safety and suggests EUR/USD might be a good place to place long vol bets.

I mentioned how the risk reversal (RR) price had come down from the highs. This is certainly true of the 25 delta RR, but that may also be because of the strikes one gets on the downside, which may no longer cover the area where market short strikes are concentrated (1.0250 and 1.000).  If we look at the three month 10 delta RR, it has also been lower but is much more elevated (almost double the cost) than the 25 delta RR.

To construct this example, there are a few ideas we want to take into consideration: 

1. We know over the last two years there has been a negative correlation between EUR/USD spot and implied volatility.
2. We know that the July contract will have the catalysts of the next ECB and the next FOMC meetings where we will also hear forward guidance from each, as well as see their interest rate decisions.
3. We also know from the term structure graph that July implied volatility is high relative to the months around it because of these catalysts.
4. We know there has been activity in EUR put/USD calls and that the 25 delta puts have flattened more than the 10 delta puts.

Putting this all together, I have an example that can be viewed in either a direction or a volatility lens. First, from the directional lens, I want to get short spot as it is moving below the 1.0500 level that has held several times the last five years. This is the area where we go into the unknown. If I am bearish on EUR/USD spot, I want my position and my P&L to accelerate as we move lower. Nevertheless, I am also realistic and know that the 1.0250 and especially the 1.00 level should have plenty of interest on the bid given the cluster of open strikes and digitals in the area. While we may accelerate on a move through the old lows, there will be some stickiness as we get closer to the strikes the market makers may be short. Second, from a volatility standpoint. We talked about the spot/vol correlation. As we go lower, I want to get longer options with the expectation that implied volatility will move higher. I want to have some inventory from which I can possibly sell if the level of implied volatility exceeds even my forecasts.

Combining these two thoughts, I put together what looks like a butterfly, but isn’t really. In this spread, I sell one ATM July 1.0750 put. July volatility is high, so I take advantage to sell the ATM. Then I buy three of the July 1.0500 put. This is the old low through which we can accelerate. It is also the 25-ish delta area that has come in relative to the ATM (Figures 4 and 6). Finally, I sell two of the July 1.0250 puts. This is the area of possible friction and the 10 delta area that has stayed relatively elevated vs. the ATM and 25 deltas (Figure 11). I take in premium to do this. The position profits on a directional basis if we move lower. As we get to 1.0500, I am net long gamma and front date vega that I can use to trade around. If I am completely wrong and spot moves higher, I have no delta and no vega, but earn the premium I have taken in. Nothing is without risk. In this case, the biggest risk would be going to the 1.0500 area in spot and sitting. The position would lose on a direction basis as the theta kicks in on this pseudo-butterfly. It would also lose as implied volatility would potentially come lower. Given the catalysts in the market, and the notion that subsequent moves to major support either shows a break or a bounce, a trader may be willing to take those risks.

There is an increase in varying opinions about the path forward in markets these days. We continue to have several catalysts in front of us. Whether a trader is bullish or bearish, in this case in EUR/USD, there is always an idea that can come from the options markets.

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