Profiting on Brexit Options Requires Pound to Drop at Least 2.4%

  • Some investors predict a decline of as much as 20% on Brexit
  • Sterling-dollar volatility climbs to highest since 2009

For all the investor frenzy over a possible Brexit, pound bears need a decline of about 2.4 percent to make money through options should Britain choose to exit the European Union.

A trader will cover the cost of an option premium if sterling falls to $1.4193 over the next month, from $1.4545 at 4:52 p.m. in London, according to broker quotes compiled by Bloomberg.

That pricing suggests that either traders are more sanguine about the risks of Brexit, or they see less of an effect on the currency than some banks and money managers who have predicted the pound will lose as much as 20 percent of its value if the U.K. quits. A smaller move, or a gain, will see a trader lose all the upfront premium they paid for the put option.

The run-up to Britain’s unprecedented vote on June 23 has driven brokers to price in the highest one-month implied volatility since 2009. They’re seeing the pound liable to swing higher or lower by an annual 22 percent. That’s boosted the cost of options, particularly the one-month contracts expiring after the referendum’s results are published. Even so, downside protection is still not prohibitive, according to some investment advisers.

Cheap Hedge

“Considering this is the biggest volatility since Lehman Brothers’ bankruptcy, the hedge is still cheap to make if you really think Brexit can happen,” said Bruno Atlan, a former currency trader who’s now chief executive officer of New Momentum Consultant SL in Madrid, an adviser to corporations on investments. “I don’t think Brexit will happen, but hedge funds, corporates and other players are speculating on it.”

The U.K. currency has had a tumultuous start to the week as opinion polls gave conflicting messages about the likelihood of an EU exit. It fell by as much as 1.1 percent on Monday, and gained as much as 1.5 percent the following day. On Wednesday, it was little changed at $1.4545.

For money managers, options are an integral part of managing risk, with a daily average turnover of $104 billion in the U.K. alone, according to Bank of England data. The current level of volatility is raising the cost of seeking such protection. The pound’s implied volatility compares with a 10-year average of 9.3 percent, and a current level of 9.6 percent for the euro.

Preparing for Aftermath

As Brexit risks become more imminent, traders and market operators around the world are preparing for the decision. Margin requirements are getting raised, bank traders will be working overnight in London, and investors from Thailand to Boston are waking up to how their positions may be affected if Britons choose to leave the trading bloc they’ve been in since 1973.

Investors and analysts are forecasting turmoil if a Brexit occurs. Adrian Lee, the founder of Adrian Lee & Partners, which oversees $9 billion of foreign-exchange investments for money managers, predicts sterling would fall 20 percent on a vote to leave the EU over the course of two to three days, with much of it on day one.

A Bloomberg survey of economists in February showed 29 out of 34 economists in a Bloomberg saw it sinking to $1.35 or below within a week of a vote to leave -- levels last seen in 1985.

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