FX Quant Strategy provides a quantitative overview of the currency market, including several valuation tools and monitors, focusing on the FX options market.
This week we recommend the following FX option trade:
- Enter bullish 1M USD/NOK risk reversal
Weak risk sentiment and falling US interest rates have dominated price action over the past couple of weeks, resulting essentially in a stronger EUR and a weaker USD. According to our spot valuation model, however, the USD reaction seems overdone and the greenback is now significantly oversold versus the NOK, EUR and CAD.
Implied FX volatility has generally traded higher in recent days with the short ends rising the most. From a valuation point of view, prices on longer dated options both across majors and in scandi pairs generally look 'expensive', while the short ends remain 'neutral' despite recent flattening of the volatility curves. Hence, from a risk-reward perspective, we currently see little value in short gamma strategies in the 0-1M segment. In terms of option market positioning, we observe that the weak risk sentiment and the decline in US interest rates have prompted a significant increase in USD put premiums relative to similar call options. According to our option skew valuation model, USD put options are now very expensive evaluated by a volatility-adjusted z-score of 25 delta risk reversals.
In the short term, we prefer to take advantage of the excessive weakening of the USD via risk reversals as the recent spike in prices for buying USD protection offers attractive break-even ratios on the puts and calls. While the weakening of the USD has supported oil prices and thereby the NOK, the substantial move lower seems overdone in relation to the moves in relative rates and oil. Technically the cross has reached levels which could trigger a correction and fundamentally we also expect the cross to move higher in the coming months, albeit poor NOK liquidity allows for significant intra-day movements. In sum, from a risk-reward perspective we find a long 1M USD/NOK risk reversal the most attractive.
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