Pound Option Traders Are Not as Short as Risk Reversals Suggest

(Bloomberg) -- While the option market is the most bearish on the pound in two years amid Brexit anxiety, it’s by no means a one-way street.

Demand for sterling calls has been almost as strong as that for puts since mid-June, data from the Depository Trust & Clearing Corporation show, even as risk reversals showed faster increases in the cost of contracts to bet on pound weakness.

• While pound volatility rose disproportionately in favor of put options over the past four months, demand for structures benefiting from a stronger sterling haven’t been out of vogue
• Looking back at trades since mid-June, when a strong rally in risk reversals led by puts started at the back end of the curve, a total notional of 297 billion pounds ($391 billion) traded for vanilla options. Out of these, 155 billion pounds represented put structures, or 52 percent

• By and large, the difference in implied volatilities between similar-maturity call and put options reflects market expectations in terms of the direction of a pair and reveals investors’ positioning. A negative number, especially a deep one as that for pound risk reversals, suggests the market expects a substantial move downward in the U.K. currency
• In theory, this would translate to traders adding dollar calls by a greater margin; reality suggests that either investors are hedging short-pound cash positions or simply taking advantage of relative cheap pricing to bet on Brexit resolution
• The pound could gain more than 2% to $1.35 if a divorce deal is agreed, or slide as low as $1.20 if Britain crashes out of the bloc without an economic agreement, according to strategists
• NOTE: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

©2018 Bloomberg L.P.