October 12, 2009 / 5:31 PM / in 9 years

Fear persists in currency options market

NEW YORK (Reuters) - The weak U.S. dollar has fueled anxiety for currency reserve and fund managers watching the value of their portfolios erode, increasing the dollar’s volatility against some currency pairs in the options market.

Key measures of market sentiment are also showing abnormally high prices for options used to protect against risk, indicative of nervousness even though risk appetite has improved as major world economies appear to be on the mend.

“The weaker the dollar and the higher the euro, the more uncertainty is going to be priced into the market,” said Andrew Wilkinson, senior market analyst at options market maker Interactive Brokers in Greenwich, Connecticut.

On Monday, one-month implied volatility on euro/dollar, a measure of the market’s expectations for a currency’s trading range, rose to 10.33 from 9.98 last Friday. Realized volatility, on the other hand, a gauge of an asset’s actual price movements, also crept higher to 7.47 from as low as 6.94 last week.

Market participants also say investors have been using the options market to hedge their short dollar positions, purchasing euro or Australian dollar puts as portfolio insurance in the event of an unexpected gain in the greenback.

Puts generally reflect expectations an underlying asset will fall. However, when sentiment on a currency is decidedly bearish, like the dollar currently, investors often use the options market to hedge their cash position. Therefore, an investor with a bet on further euro strength would potentially buy euro puts.

Wilkinson said investors at the moment are at a loss about the near-term direction of the dollar.

“People are wondering whether we’re going back to $1.46 in euro/dollar or heading toward $1.54. But one thing is for sure, as we head toward $1.50, we’re going to experience a lot of volatility.”

SENTIMENT POINTS TO CONCERN

On Monday, risk reversals, a measure of currency sentiment in the options market derived by looking at the difference in implied volatility between out of the money calls and out of the money puts, show a bias for euro puts, trading at a mid-market level of 0.2. That means investors are hedging their short dollar positions with bets for a euro downside even though no one expects the euro to fall.

Reuters data showed that the implied volatilities of euro puts were higher than vols of euro calls, indicating a heavy short dollar position that needed to be hedged.

The implied vols on one-month 25-delta euro puts traded at 10.6 on Monday, compared with 10.450 for vols on one-month 25-delta euro calls. (Delta refers to the probability a particular option will end up in the money; a 25 delta has a 25 percent chance.)

Discomfort with the action in the dollar extends to emerging market currencies as well.

One important gauge looks at the ratio between 10-delta risk reversals and at-the-money implied volatility. A high ratio suggests anxiety over an asset’s price; a low ratio suggests investors are comfortable with the current price level.

The drop in the dollar against the Brazilian real has raised alarm signals in the options market, with the real surging 32 percent this year.

The dollar/Brazil’s 10-delta ratio on Monday was at 0.75, according to Reuters data, higher than it was more than a month ago when things were less upbeat.

“These are expensive 10-deltas relative to their implied vols, which suggests to me there’s stress in the market,” said Simon Smollett, senior options strategist at Calyon in London. “Investors are still paying a very high price for the protection so there is a sort of unsettled feeling.”

Given the low probability that a particular currency will hit the level implied in the 10 delta, those options trade at lower premiums. (The 10-delta isn’t even the market’s convention because they’re so far out of the money, with Smollett referring to them as “lottery tickets.”)

Some investors may use 10-deltas to hedge their books, which are relatively inexpensive compare with the more commonly watched 25 deltas. However, Smollett says the options market right now is putting a very high price on these “lottery tickets” in the dollar/Brazilian real.

“When investors are uneasy about risk, these 10-deltas would get expensive,” he said.

Expensive 10-deltas are evident in other currency pairs as well, notably, dollar/sterling, euro/sterling, sterling/Swiss franc, and the Australian dollar/yen, based on Reuters calculations.

Editing by Leslie Adler

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