Executive summary

As volatility levels fluctuate in the FX markets, Rich reviews two strategies in different currencies:

  • JPY/USD ratio spread for volatility to remain elevated
  • MXN/USD call vs. put spread for volatility to pick up from a low base

2022 has been a year for macro moves. COVID-19 problems continue. There is a land war in Europe. There are fears of economic slowdown in Europe and the U.S. caused by inflation, which has brought aggressive central bank policy into play. There is a seemingly endless supply of negative or potentially negative headlines. This brings me back to my early days in the market when I started on the CME Group floor trading FX options. I know these markets get the most interesting when there are major macro stories in the world.

The first stop for me was to go to CME Group’s Volatility Index (CVOL) to view how the level of volatility looks relative to the last six months or so. With all these headlines, is a good amount of future volatility being priced in already?  From Figure 1, we can gather that G5 FX –  the major currency pairs – all are seeing volatility levels that are elevated versus the last six months of history, particularly JPY/USD. On the flipside, MXN/USD is at the low end of its range.

Figure 1: CME Group FX CVOL

Thus, I wanted to look into JPY and MXN, as the levels of volatility relative to their range suggest there could be an opportunity. What if there was a product for which the short-term chart was suggesting much higher levels, but was close to the downtrend of a 30-year channel? You might think I was referring to 10-Year U.S. Treasury Yields. In fact, I am referring to USD/JPY. Figure 2 shows USD/JPY for the last 35 years. I find it interesting because when I first went to Japan for a study abroad program in 1986, I remember thinking how inexpensive everything was. I went back again in 1989 and 1991. Each time, goods were seemingly more expensive. The included chart shows this entire period with some other interesting annotations. The low was at 79.75 in 1995, which I point out because I was short gamma in USD/JPY at that time and actually sold that low price. Nothing like selling the low. I was very happy then in 2011, when a new low was set. I no longer had the record for the worst USD/JPY spot trade in history. You can see in 2012-2014, the USD got quite a bit stronger versus the Yen. This trend coincides with the election of Prime Minister Abe and the introduction of his Three Arrows plan. According to Wikipedia: Abenomics is based upon "three arrows" of monetary easing from the Bank of Japan, fiscal stimulus through government spending, and structural reforms. After that initial weakening, the yen went sideways for the last seven years, and this downtrend line remained intact. That is, until recently. While major central banks around the world are in various stages of tightening monetary policy to combat inflation, the Bank of Japan recently re-confirmed its zero-rate policy. Presumably, this is an attempt to import the inflation from the rest of the world into the Japanese economy, which has been fighting deflation for decades. This news caused the U.S. dollar to strengthen vs. the yen and finally move above this long-term trend line.

Figure 2: USD/JPY

This gets me interested. Yes, the level of volatility looks quite high relative to the last six months, but I know it has been higher. The reason I sold the all-time low in 1995 was because I was short yen vega in the 20s. I went back to the CVOL tool to look at yen volatility through history. The current level looks a lot more reasonable on this longer-term view below the mid-point of the range.

Figure 3: CME Group FX CVOL Historic Volatility

JPY/USD Ratio Spread example

When asset prices move into a new area it always suggests to me that it is time to get long some convexity for potential profit. There is the risk that this is a head-fake and prices could move back below trend. However, the Bank of Japan (BOJ) is giving macro fund managers the green light to use the Yen as the funding currency of choice for carry trades and for leverage. The BOJ is sending a signal to the hypothetical Mrs. Watanabe, the Japanese retail investor that has been forced to invest in overseas bond markets in search of yield, that there is less risk of Yen strength which would hurt those overseas investments.  In the FX market, skew can move quite a bit so I looked to see what was being priced in at the current moment. I must admit I was surprised to see skew so flat between 25 delta calls and puts.

Figure 4: JPY/USD Skew

This relative pricing, and the possibility for a big move toward yen weakness, drove me to look at the ultimate convexity strategy. This is not for the faint of heart, because it is a bet on a big move occurring. If we don’t move much, as we get nearer expiration this strategy decays very unfavorably for the investor. However, if the move is weaker in yen, higher in USD/JPY, there can be greater gains. It is a zero-cost ratio put spread, but one in which the trader sells one option at-the-money or even slightly in-the-money, to buy three out-of-the money puts. It can be done for zero cost. If there is a small move lower or the underlying sits, as the QuikStrike breakeven shows (Figure 5), the strategy would erode into losses over time. However, with a big move in either direction - the position will either profit greatly or at least not lose. For example, selling one of the 0.0081 (123.45 USD/JPY equivalent yen put) to buy three of the 0.00785 (127.39 USD/JPY equivalent Yen put). The breakeven at the June expiration is 0.00723 (129.50 USD/JPY equivalent), but it profits much sooner if the move happens more quickly. This is the type of idea where I want instant gratification. If the position does not get this move in the next couple of weeks, I would close the structure and move along. The biggest risk is the market sits and nothing happens. I don’t want to hold on too long if there is no movement.

Figure 5: USD/JPY ratio spread


The other product that stood out from the CVOL list was MXN/USD. This is a very interesting currency pair right now. First, because of the USMCA relationship, Mexico’s economy and currency are very tied to the U.S. economy. There is increasing caution that the U.S. economy may begin to slow meaningfully. If this were the case, the MXN could weaken. Figure 6 shows the MXN/USD vs. the U.S. PMI number. The horizontal line is at the 50 level, which is generally thought to be the level that connotes expansion or contraction in the U.S. economy. The MXN is currently at 0.0501. but if the U.S. economy were to go to 50 in the PMI, recent history might suggest we see a move toward 0.046 or so.

Figure 6: MXN/USD vs. U.S. PMI

However, Mexico has another driver for its currency, and that is the price of oil. As a major producer and exporter of oil, the Mexican peso is considered a Petro-currency that appreciates when oil goes higher and depreciates when oil weakens. Perhaps because of the uncertainty in the U.S. or European economies, or perhaps because of the fear that oil prices that are too high could slow economies, the MXN has not appreciated with the price of oil the way it has historically.

Figure 7: MXN/USD

From the initial CVOL chart, MXN volatility is on the lower end of its six-month history; thus, I should not be overly worried about getting long options in a strategy. My strategy is to somehow try to trade the upside in MXN, leaning on the fears that traders may have of downside in MXN from the potential U.S. economic slowdown. In this example, that means to sell a put spread on MXN to finance MXN calls. I didn’t want to sell puts outright in case the economy does slow down. Thus, a put spread was sold to reduce the risk. However, the major impetus for this strategy is for the currency to catch up to the price of oil, perhaps because the U.S. economy does not slow as quickly as feared. So, a 0.047-0.045 put spread was sold to buy 0.0525 calls. Figure 7 shows 0.0525 could be a minimum move if the MXN catches up to oil. In fact, 0.06 or higher would not be out of the question. This strategy was constructed for zero cost, meaning sitting here until June expiration; even a small move stronger in MXN does not hurt the position. The biggest risk is MXN is below 0.047 at expiration. However, the losses are maxed out at 0.045. The QuikStrike Spread Builder (Figure 8) shows the breakeven graph.

Figure 8: MXN/USD call vs put spread

The examples this week are both levered ideas to take advantage of potentially large directional moves. However, I know from my days in FX, when currencies begin to trend, they can trend for some time. Stan Druckenmiller even said so much recently when he said, paraphrasing, old-timers know when the Yen trends the Yen trends. In fact, the BOJ is seemingly inviting traders to consider this by easing policy when all other major central banks are tightening policy. There are three major funding currencies for macro investors and reserve managers: EUR, JPY and USD. Only one of these is easing policy. You can gather how these investors are thinking.  The MXN is not a small idea either. One is based on a big potential move that is not appreciated because of the divergent signals from the data and the drivers. One should take a view on what will affect Mexico more in the coming months – commodity prices or the U.S. economy. You may not agree with the view. I get that. If so, this is not the scenario for you. However, if you possibly consider higher for longer in the price of oil, my levered strategy on the MXN might be right in your wheelhouse.

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