Wednesday, 19 February 2014

EUR vol too low?

Volatility has been on a downward path for years, and given the persistent weakness in the USD, its no surprise that implied vols are low.

Today we saw 1 month implied vols leg lower into the 5 handle with spot pushing higher through 1.3750, this level of IV has not been seen since mid 2007, however it does seem to have found a floor at around 6%

EUR 1 month ATM IV
Here is a bigger picture, this time with the 3 month Implied Vol, and 60D realized vol (red), both have been storming lower.

EUR 3M IV and 60D realized vol
While we have been firmly below the historic mean for volatility, I think that is about to change. The EURUSD has been stubbornly strong built from a strong, and growing, current account surplus. This being said, even with the bullish factors, there are a multitude of bearish ones, one of which is the diverging monetary policy which should play out eventually - at least when the market moves to pricing from the forward rate spreads as opposed to spot yields (Here)

Now looking at the technical picture we can see the EURUSD is at very critical crossroads. Teetering on the edge of a potentially explosive break higher (and through 1.40, maybe even 1.42)

EUR daily chart, with implied yields in red
While there may not be a clear fundamental reason for a break higher (slowing US?, un-taper?, EZ inflows?) the clear technical picture shows the potential breakout from a >5y trendline from the all time highs. 

Conversely, if we have short end US rates picking up further, the EUR will likely fail to hold the mid 30's and topple over towards 1.28/1.31. 

Where the trade idea comes from is that I see it unlikely that in 3 or 6 months out we will be in the same situation. To me, its pretty binary - we break higher, or we topple lower... Both will be of sizeable magnitude as the importance of the current trendline can not be forgotten.

So this is where it links to the volatility aspect - I can't be sure which way we go from here (my bias is to the downside), but what I am confident is that we will finally see a definitive direction to the EURUSD.

When looking at the vol term structure, we see that, across the curve, Implied vol is very low - but its almost flat out too around 6 months

EUR ATM vol term structure

EUR vol surface
The vol surface somewhat backs up the idea of looking at a purely vol based trade and having no directionality, as we can see there is no significant skew in the smile at the short end of the vol curve - that is to say, puts and calls are of similar expense.

As such, given the above points, positioning "long vol" seems sensible to me. Structured simply via buying a 3 month ATM straddle.
EUR 3M straddle calculator
As we can see from this, the market needs to move about 350 pips either side of 1.3750 to be in profit at expiration in its most simplest form, but also the vega/theta is around 27 days, so if we see a move higher in IV then the trade should profit also. N.B. probs will delta hedge based on short term movements to get the most out of it.

Bonus chart - EUR is starting to move to away from my short term fair value model

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