Back in April of this year, I looked at the G5 FX market and saw elevated levels of volatility. This initially attracted to me to opportunities in JPY, which had the highest volatility relative to its range over the last six months. Upon digging in further, I looked at USD/JPY spot breaking out from a long downtrend and saw that JPY implied was actually pretty reasonable relative to its all-time history. The drivers, I suggested, were the ties to the U.S. Treasury market and the potential demand for leveraged accounts to use the JPY as a funding currency. At the time, I said one should consider buying a ratio Yen put spread, taking the risk that futures slowly drift lower with the prospect of a big payoff if the move lower accelerated. Over the course of the next two months, the move lower did in fact accelerate.

Now, when we look at the same market, with the same drivers, the story may be quite different.

One driver of the USD/JPY spot price is the spread between U.S. Treasury bond yields and Japanese government bond yields. As the spread is widening, global investors sell their JGBs to buy U.S. Treasuries, swapping their yen for dollars and driving the spot price higher. In addition, leveraged accounts look to borrow in yen and take advantage of wider spreads, further strengthening the Dollar further weakening the yen on a relative basis. As we look at the last 30 years of prices, we can see this impact.

The weakness of the yen has also served to drag the CPI higher in Japan. Whether this was an intended policy move by the Bank of Japan (BOJ), which has struggled generating inflation for decades and saw the opportunity now as global central banks are fighting it, or simply an outcrop where weaker currency prices which mean the cost of exported goods are higher. Either way, we can see there is a relationship between inflation and FX. If this is an intended policy of the BOJ, how much higher do they want to let the inflation rate go? How much weaker of a currency would they support?

Are there any signs that the weakness of the yen has possibly gone too far? Looking at a weekly chart, we can see the yen moving off lows around .0072 and already up to .0076. The weekly MACD is tuning higher and crossing over. The RSI is coming from oversold levels. These are positive developments technically.

However, if we look at the shorter-term daily chart, we can see the yen is running into some resistance at the Ichimoku cloud, the MACD is stretched, and the RSI is entering overbought territory. The lack of confirmation of the weekly signal from the daily chart may suggest that there is some near-term churn in the futures prices around these levels.

Turning then to the options market, we can see from the CVOL history chart that as the yen weakened materially into a region we had not seen for quite some time, implied volatility accelerated higher. This is not uncommon for implied volatility to do this when prices move into uncharted territory because there is rarely any open interest to provide friction, and often the market is still struggling to understand how much further it can move. As the market stabilizes, implied volatility can come lower. We see exactly this as CVOL touched a little above 18 but has since settled in around 12. While this level is a fair bit lower than the highs hit in June, it is still almost double the implied volatility seen in the 2020-2021 time period.

When we look at where options are trading, it is the call side of the ledger that lacks any volume. Over the last two weeks, the volume has been concentrated on the Yen put side and strikes that are now at-the-money. The intraday chart shows how the volume has been more in the Yen puts. We have run into the friction and the daily charts suggest we might churn here some.

Turning to the futures market, the Commitment of Traders shows that the interest by leveraged accounts shorting the yen have been declining for several weeks. It is still larger than the interest to go long the yen, but the net position has been getting less short. This may indicate some indecision, fatigue, or simply that everyone who wants to borrow in yen has already done so.

In spite of this, the skew in the options market favors the calls over the puts. I look at the constant maturity 25 delta risk reversal and see there is a 1.3 vol premium for the calls over the puts. While we can see the risk reversal price has moved on either side of flat this year, we are near the biggest premium for calls over puts this year, even though there is not much volume trading on the call side, and levered accounts don’t seem that interested in being long. This could perhaps be that the nervous side of the market is on a move higher in yen given many hedge funds and asset managers are now structurally short.

If we break this skew down into the call side and the put side, we can see from the call skew, there is a 0.8 vol premium for 25 delta calls over the ATM calls.

While the 25 delta puts are trading 0.5 vols below the ATM puts.

Pulling this together, there are catalysts for a potential move higher in the JPY. The Treasury/JGB yield spread is beginning to narrow and may continue to do so. There is no shortage of macro accounts that are espousing getting long bonds here. This has historically meant a lower USD/JPY spot or a stronger yen. The skew is higher for Yen calls than puts and for OTM Yen calls over ATM calls. Thus, it may not be that attractive to look at buying Yen calls as a way to play this. While the implied volatility has moved higher with yen weakness and now back lower with yen strength, it is still elevated on a multi-year view. Typically, higher call implied volatility suggests the market thinks volatility will move higher if yen strengthens but this has not been the case this year. Technically, there is reason to think we could see a move higher in yen in the coming months but near term, there could be some churn in a range which could lead to lower implied volatilities still. Is there a way to take advantage of implied volatility that may come lower, especially where it is highest on the OTM Yen calls, while still protecting against a directional move higher?

I looked at a Yen call Christmas tree for exactly this scenario. If we look at this directionally, we can buy one  September 0.0077 call, sell a 0.0079 call and a 0.00805 call. I would be spending 28 ticks to place this order t but it gives me an attractive range to make a profit from 0.00728 to 0.00822. The trade decays positively for me as we move higher and closer to my short strikes. An abrupt move higher in the short-term would not be good for this strategy.

Another way to think about this is as a short volatility trade. A slow move higher should lead to declining implied volatility back to levels we saw earlier this year. As we move higher, we are short twice as many contracts as we are long. We derive into short vega at a level that seems to be attractive. The long option has a 11.7 implied volatility while the short options are 12.8 and 13.8 respectively. With short-term charts suggesting congestion, even if the trend may be shifting, we could see a move lower in implied volatility and we are short the higher vol options. In addition, as the market starts to accumulate volume and open interest on the Yen call side, there may be less premium for the calls over puts and we could see skew start to flatten. We can simulate this scenario in QuikStrike and see what a slow move higher would do for the P&L of this strategy.

Whether your view is directionally, or from a vega standpoint, the September Yen call Christmas Tree may deliver the gifts you are looking for. It is not without risks, an abrupt move higher could lead to losses from having an open-ended tail exposure. A move back lower in the yen will also cause the loss of some premium. However, if the idea of a slower move higher in the yen fits your view, this idea might be for you.

Good luck trading.

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