Euro Could Be Facing a Dark Winter With Options Traders Spooked

(Bloomberg) --

FX traders are forecasting a cold, stormy winter for the euro.

Markets are increasingly nervous about the common currency with the pandemic resurgent, geopolitical tensions rising and gas supply issues mounting. Risk reversals in the euro-Swiss franc pair fell below parity on Nov. 1 for the first time in almost a year -- coinciding with a jump in one-month euro-dollar GARCH, a statistical modeling technique that helps predict the volatility of financial assets. Then, this week, that cross dropped to a six-year low.  

But it was euro-dollar pair’s breach of the psychological 1.15 level on Nov. 10 that appears to have really spooked options accounts. Euro options turnover has remained elevated since then, driven by higher realized volatility and short-dated put demand as downward momentum exposes trading barriers. 

Daily options volume has averaged 22.8 billion euros in the past week, according to Depository Trust & Clearing Corp. Puts are outpacing calls by 4-to-3, and more than 9 billion euros of exotic options have been booked over that time. The demand has helped lift at-the-money volatilities to the highest level in months and briefly shifted one-month skews to the most bearish for the euro since May 2020.

While volatility usually falls as holidays approach, the upcoming options expiry calendar and shape of the yield curve paint a different picture. On Nov. 24, about 4.2 billion euros of 1.1500 strikes and 1.6 billion euros of exotic options booked on DTCC will expire, making by far the largest single day of expiries before year-end. With the exception of 4.8 billion euros of exotics that expire just after the December Federal Reserve and European Central Bank meetings, there’s a relative dearth of expiries. 

Free from option constraints, the euro can continue to oscillate as central bank policy meetings approach amid thinning liquidity. Skews are bearish across tenors, so any further spot deterioration will likely see implied volatility firm. Meanwhile, a move back above 1.15 would change the volatility outlook entirely.

Looking to 2022, traders appear eager to capture election risks and rates volatility, particularly a potentially hawkish tilt by the Fed. Even before the euro dropped below 1.15, they were loading up on longer-dated options. Yen and euro one-year implieds have moved higher since the middle of September -- a sign that the low volatility regime among carry currencies is shifting. (On Thursday, one-year implied volatility on the Canadian dollar touched a three-month high.)

NOTE: Robert Fullem is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

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