Foreign Exchange Options trading volumes spiked in March in line with increases in FX volatility due to the coronavirus pandemic and unsteady economic conditions globally. The question now is – what can FX Options traders do to navigate their way through a market filled with new uncertainties?
FX Options trading volumes rose 1.5 times in March, and we saw the USDJPY FX and EURUSD FX Option volumes increased three times and two times compared to their average monthly trading volume. The front-end implied volatility across G10 reached unprecedented levels in March before falling the following month. Reduced activity in FX Options, though, did not push FX back to their previous average levels.
Looking at the term structure of the implied volatility curve across many G10 pairs, not all parts of the curve moved in the same fashion. Just before the lockdown measures in Europe, the front end of the curve elevated, reflecting uncertainty about government actions and market responses. The back end of the curve remained low, and then became elevated two months later. While there is a bit more certainty reflected in a lower front end volatility, the back end is pricing in further uncertainty for the third quarter to the end of the year, due to further possible negative interest rates, the US elections, renewed US-China tension, and a possible second wave of infections requiring further restrictions.
So, what information and tools should FX Options traders be considering going forward to hedge against further uncertainty?
Looking at recent market activity, traders have implemented different strategies such as FX forwards, Put Spreads, and Risk Reversal. As many compare recent market moves to the previous financial crisis, which strategy has historically performed the best under those circumstances? Bloomberg FX Option pricing and back-testing tools show that certain leveraged Risk Reversal strategies performed much better than FX forwards did under similar circumstances.
Another trend we have seen is that FX traders have had inconsistent experiences with liquidity, leaving some to wait on the sidelines. Many traders are more comfortable with getting pricing from their favorite banks and want to keep it that way. Some traders, during a recent Bloomberg webinar, said that they still rely heavily on voice and chats. Others are finding they are getting more options for liquidity by using electronic trading, where they can access a greater pool of liquidity providers by using an API auto-pricing or manual pricing via an FX Options request for quote (RFQ). They say they can see all prices simultaneously and get a better, more competitive price.
Many asset managers and hedge fund managers are utilizing new functionality for pre-trade account allocations, allowing trades to be allocated across multiple accounts or to prime brokers and custodians.
Overall, FX Options traders want trade negotiation to be simplified and are turning more often to multi-dealer platforms. MDPs provide a fluid workflow, allowing them to compare prices “apples to apples,” simplifying the decision process and providing detailed audit trails.
Most of all, traders need to ensure that their trades meet the requirements of any regulated environment. In the European Economic Area (EEA), trades need to comply with all stipulations of the Markets in Financial Instruments Directive (MiFID II) and be transacted over a multi-lateral trading facility (MTF). In the U.S., trades must adhere to Dodd Frank laws and be executed over a swap execution facility (SEF). Many FX Options traders prefer to use MDPs that have full regulatory functionality and workflow that can support their trades from beginning to end.
Reporting is another essential in today’s FX marketplace. FX Options traders need technology that will easily document events leading up to and including the trade. Did they get competitive quotes? Can they generate an end-of-day execution report? For regulated trading, can they prove best execution?
Today, FX Options traders have numerous ways they can save time and money by harnessing the power of technology. The question is will they take the time and effort to do things differently? The challenges of creating alpha in a regulated marketplace may not give them any other option, but to embrace new technology developments.