Will EUR-USD Parity Repeat?Two men adventuring in the wild. They see a tiger racing towards them. They turn and start dashing away. Then, one of them stops to put on shoes. “What are you doing? The beast will outsprint you despite those” says the other. “I don’t have to run faster than the tiger” he retorts. “I just have to outrun you.”
FX stories are not dissimilar. Relative strengths and weaknesses facilitate price discovery between currency pairs.
On 1 January 2002, twelve EU countries move to euro in a historic event. Since December 2002, the euro has always traded above parity to the US dollar. The only exception is the last quarter of 2022.
EUR/USD has been above parity since late 2002 except for Q4 2022
Despite the collapse of regional banks, US corporations and consumers are in the pink of health. Cracks are starting to show in certain pockets but none too alarming (just yet).
In contrast, economic conditions in Europe are in sharp deterioration. Arguments abound on the direction of the euro ahead.
Following the rate decisions by the ECB and the US Fed last week, volatility in the Euro/USD pair has been trending to near 12-month lows. Low volatility equates to lower premiums on options. Periods of low volatility are opportune time for buying options.
This paper posits that euro will carry greater risk to the downside. That said, geopolitics and economics could turn favourably to the euro resulting in a rally. To seize opportunities presented by the price action, this paper posits a long straddle to benefit from low volatility & a euro that is set to move.
EURO SKEPTICS OBSERVE MANY PROBLEMS
Talk of the euro falling back to parity is once again creeping into the market murmurs. Google search on euro parity is at levels last seen in Nov 2022.
As reported by Bloomberg, last month, Nomura, Rabobank & ING analysts forecast the euro to get to levels marginally shy of parity to the USD. The likelihood of the euro hitting parity by early next year have more than doubled, as per Bloomberg options model.
Strong US economic fundamentals, rising US yields are bolstering the dollar. Rate differentials between the two tilts in dollar’s favour. US Q3 Real GDP was up by an annual rate of 4.9%, more than double the growth rate for Q2.
Additional tailwinds for greenback include sluggish Eurozone economic growth, concerns linked to Italy’s government debt, and slowdown in destination markets for Eurozone's exports.
OTHER ANALYSTS BELIEVE THAT EUROZONE PESSIMISM IS ALREADY PRICED IN
Disagreeing with euro sceptics are analysts with a view that Eurozone pessimism has been baked in.
Eurozone GDP fell by 0.1% in Q3. Despite feeble GDP data, market reaction was stoic. That points to an "invisible" floor for the euro. Lack of growth is priced in.
FOUR CHARTS CONTRASTING US EXCEPTIONALISM WITH GROWING EUROPEAN WEAKNESS
US GDP continues to expand at a remarkable clip given the size of the economy. In sharp contrast, Eurozone GDP growth is fragile and steadily losing steam.
US GDP racing ahead with Eurozone GDP losing steam
US inflation, while softening, is showing signs of spiralling up, thanks to its resilient and tight labour market. This puts the Fed on a hawkish stance supporting USD.
Inflation still above central bank targets but US inflation raging higher than in Eurozone
Meanwhile, the ECB might have headroom to ease rates thanks to slowing inflation and might be forced to loosen up to support growth and to stem economic contraction as shown below.
Composite PMI in US in expansion territory compared to sharp contraction in Eurozone
Monetary policy divergence between the Fed and the ECB has prevailed since early last year when the Fed was quicker relative to ECB to crank up rates.
Interest Rate Policy Divergence in US has continued to remain in favour of the dollar
In summary, the USD is poised to strengthen against the Euro, given strong GDP, higher US inflationary environment, sharp contraction in Eurozone, and continued monetary policy divergence.
TECHNICALS ALIGN WITH FUNDAMENTALS POINTING TO WEAKENING EURO
Momentum based indicators signal further weakness in the euro while oscillators point to strengthening based on near term mean reversion.
Overall, across twenty-five indicators curated by TradingView, eleven signal weakening, ten neutral, and four point to strengthening.
TradingView’s Technical Signals Dashboard point to euro weakness
CFTCs Commitment of Traders (CoT) report show that leveraged funds are net short. Asset managers who are still net long are gradually reducing their long positions.
In contrast to fundamentals, technical, and CoT reports, options market data points show that traders are bullish for euro to strengthen. Put-call ratio at 0.76 shows larger open interest on calls compared to puts.
That said, over the last one trading week, options traders are increasing puts compared to calls suggesting shifting market sentiments leaning towards a weakening euro.
Implied volatility based on options market is near 12-month lows with the conclusion of central bank meetings across both sides of the Atlantic. Low implied volatility makes premiums affordable.
CVol Index is at near 12-month low (Source: CME QuikStrike)
HYPOTHETICAL TRADE SET UP
Affordable premiums offer the best opportunity for buying options. When ambivalence prevails on the path ahead for the euro, traders could consider a long straddle to leverage volatility expansion and price action.
This paper posits a long straddle at a strike of 1.0845 on CME EUR/USD options expiring on 5th April 2024. A long straddle comprises of two legs: (a) long position in a call, and(b) long position in a put, at the same strike and expiry.
Each CME EUR/USD Monthly options contract delivers an exposure to 125,000 euros. Take the settlement prices as of November 3rd as an example, premiums for the (a) long call at 0.0182, and (b) long put at 0.0187, aggregate to 0.0369 for the long straddle. This translates into USD 4,613 in straddle premiums.
The straddle has two break-even points (BEP) at expiry. BEP on the downside is at 1.0476. BEP on the upside is at 1.1214.
The pay-off from the straddle is illustrated in the chart and table below.
Pay-off at Expiry from Long Straddle (Source: Mint Finance Analysis)
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Longstraddle
DXY and the Dollar TrapIn global finance, everything is relative. For now, there is no good answer to the perennial question: If not for the US dollar, then what?
That is why, despite all its flaws, the dollar remains the ultimate haven currency. And the US Dollar Index (“DXY”) measures the performance of the US Dollar against a basket of six major currencies of USA’s major trading partners.
The DXY measures USD performance against currency majors. Euro, Japanese Yen, and the British Pound represent more than 80% of aggregate weight.
Intriguingly, the absence of emerging majors such as the Chinese Yuan (CNY) and the Australian Dollar (AUD), stands out. The DXY will likely be modified in the future to reflect shifting global dynamics.
History of the DXY
The DXY was first created in 1973 after the establishment of the Bretton Woods agreement which abandoned the gold standard. The index has since been modified just once when the Euro was established as the official currency of the EU.
The DXY commenced with a value of 100 in 1973. The Index above 100 signals that USD is stronger than the basket compared to 1973 values. Meanwhile an index below 100 points to a weak dollar.
The current DXY value of 104 indicates that the USD is 4% above the value of the basket relative to its value in 1973.
During periods of major global financial upheavals, the DXY tends to drift away from 100. In the 1980s as the Fed hiked rates aggressively, the dollar’s value soared. Eventually, the dollar was intentionally weakened in an historical agreement known as the Plaza Accord.
Why would the US weaken its own currency?
In short, a strong currency is not always a good thing. A strong dollar made US goods less viable in global markets and led to a sharp increase in the US trade deficit. As such, weakening the dollar was in the best interests of not just US’s trading partners but also the US.
Another period of upheaval for the DXY was the 2008 global financial crisis. The USD was in crisis when Lehman Brothers collapsed amid the US housing crisis. The confidence in the dollar was shaken.
Comparatively, other countries were less severely affected. This pushed the DXY to its lowest level of 71.
Excluding these exceptional periods of time, the DXY trades around its base value. Movements in DXY are at times drive by policy changes in the US or its partner countries such as Japan, EU, UK, Canada, Switzerland, and Sweden. The real elephant in the room is the Fed policy. Fed decisions have an outsized effect on the DXY.
The DXY is not very volatile. Its 30-day annualized rolling volatility ranges between 5 and 10. However, major economic events can lead to a rise in volatility. Volatility spikes during periods of global crises or major events in the US (Fed Hikes) or EU (EU Debt Crisis) with both currencies having major weightage in the index.
DXY CORRELATION WITH OTHER ASSET CLASSES
Fed Funds Rate
Although not tightly correlated, Fed Funds rate has a major impact on the DXY. Higher rates make the dollar more attractive which leads to it strengthening. However, as other major central banks usually move in tandem with the Fed, rates in the partner countries also rise dampening the buoyancy in DXY.
Fed policy action has a major impact on the DXY at the beginning of shifts in policy. However, this effect soon fades as markets price in terminal rates according to expectations.
Fed & ECB Policy Divergence
The divergence of policy between ECB and Fed has a major impact on the DXY. As policies start to diverge (correlation between rates starts to decline), DXY experiences large directional moves.
2Y Treasury Yields
As treasury yields are derived from Fed Funds rate, the correlation between DXY and 2Y constant maturity treasury notes is similar. In general, both are positively correlated.
The correlation breaks during periods where rates grind lower, but the USD continues to rise. Case in point is the experience of 2020. When the US Fed drove rates to zero, the US dollar soared as the only credible haven. This is the classic dollar trap.
Furthermore, DXY and treasury yield correlation can break due to effects of economic policy action. For instance, in 2018, DXY remained muted despite rising treasury yields as markets were confident of the terminal rate and the Fed not hiking rates very aggressively.
FOMC MEETINGS AND THE DOLLAR INDEX
FOMC meetings decide the fate of interest rates. Typically, decisions move in tandem with expectations.
But when FOMC decisions diverge from consensus, impact on the DXY can be large. For instance, in its May 2023 meeting, markets anticipated the Fed to pause its aggressive hiking campaign against a backdrop of regional banking crisis. However, Fed mercilessly cranked up another 25bps driving DXY higher.
WHAT’S UP AT THE NEXT FOMC MEETING?
CME FedWatch tool highlights the probability of changes in FOMC rate as measured by 30-day Fed Fund futures pricing data.
For the next FOMC meeting on the 14th of June, CME FedWatch tool points to an 80% probability of no hike. For the meeting on 26th July, markets are pricing a 55% probability of a 25bps hike. This would take rates to 5.25%-5.5% which is expected to be the terminal rate.
In case Fed decides to hike in the June meeting, it could lead to a sharper upward move in the DXY.
COMMITMENT OF TRADERS REPORT
The Commitment of Traders report shows weekly changes in open interest by investor category. Institutional investors expect DXY to move higher as both managed money and small speculators have increased their net long positioning over the last three weeks.
TRADE SETUP
Market expectations have moved wildly from rate hike to no hike multiple times over the past two weeks.
Cooling inflation in April, signs of a weakening job market, anemic services data, credit tightening are shaping market consensus for a rate pause in June. However, if May inflation data, which is due a day before the FOMC meeting paints a different picture or the job market continues to remain strong, the Fed may throw in another rate hike.
Anticipating Fed move is difficult. Investors deploying a long straddle can potentially lock in gains from large moves in DXY if FOMC moves against consensus.
A long straddle is a delta-neutral options strategy that can be used to benefit from rising volatility in options. It involves simultaneously going long call and long put at the same delta. Delta-neutral makes the structure directionally agnostic to upside or downside moves. Loss on one leg will be offset by gains from the other leg when the underlying moves sharply.
Straddles are powerful in that they are long Vega which makes it gain not only from a directional move but also from volatility expansion. With uncertainty looming around Fed outcomes, volatility will likely spike heading into the meeting.
A delta neutral strategy would be difficult to run directly on DXY futures due to slim liquidity for these options on ICE.
As such, investors could consider long straddles in CME Euro FX options, CME Japanese Yen options, and CME GBP options to obtain similar exposure. These three majors represent 83% of the DXY and largely drive major moves in the DXY.
The above charts show the payoff for the straddle on each of these individual options. ATM strikes can provide higher profit potential with higher risk potential.
However, ~25 delta options have cheaper premium due to which the loss is limited at a lower level, consequently, 25 delta straddle would also require a larger price movement before the position is in the money. Moreover, the profit potential on these would also be lower due to wider strike levels.
A notable exception to these is the Japanese Yen put options which have noticeably lower IVs and are thus cheaper. Each of these pairs would have to move ~1.5% over the next two weeks for the position to make money.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
PINS Pre-Earnings StraddleDescription:
PINS is in its extended down trend that began on 12FEB, back below the 50D & 200D EMA.
Volatility has skyrocketed since the emotional rollercoaster that was PYPL takeover rumors, so what is priced in, and what is next for PINS?
Earnings after close on Friday.
Going for end-of-month options to evade the high premium from earnings week.
From Deltaone on Twitter: twitter.com
66% expect beat
10.9% move priced in
19.3% avg move post earnings in previous quarters
Long Straddle
Levels on Chart
Break-evens
52.47, +17.75%
37.53, -15.78%
I consider this a risky trade, so my capital allocation will be strictly limited.
Will close the position out if there is no considerable move in the underlying by 12NOV.
The Trade
BUY
11/26 50C
SELL
11/26 40P
Only invest what you are willing to lose
Break-evens vary on fill
*It is an option to turn this into Calendar Straddle by selling the same week strangle against it, thus reducing break-evens, or even creating a dual calendar spread.
I have opted against these because I trust the small potential of PINS to hit a 20% gap this week, given the earnings scene in the broader market right now.
I will update when/if I fill these
Long ATM Straddle John Deere with LOW IVR = CHEAPWe purchased an at the money straddle for a small debit of only 3.22. This trade is notably cheap because the IVR is extremely low: 2%. Being a long straddle (buying the calls and puts at 165), we are giving ourself unlimited profit, risking a limited $322 per contract.
We take our neutral position because of the positive characteristics of the trade itself, but the fundamental conditions further our thought. With an equity value of over 51 billion, John Deere is a company with significantly large exposure to China, and Chinese trade tensions. Also, interest rates have a somewhat direct effect on the profitability of this corporation. Financial Services comprises 9.2% of Deere's market cap, so as cuts in July become more of a reality, the profitability of the Financial Services division will be affected, possibly drastically. Lower rates mean lower borrowing costs for Deere, and could cause the stock to move outside of the breakevens to lead to profits.
Also, the technicals indicate the high possibility of large movements prior to maturity. The RSI, MFI and Stochastics all indicate an overbought sentiment, and the DMI DI+ and DI- indicate change in direction. The PSaR also has recently switched direction.
Long July CY straddle @ 22 due to subdued volatility (IVR of 4)We are entering into a near-the-money straddle on $CY by longing the July calls and puts with a strike of $22, for a $.60 debit. The breakevens are below 21.40 and above 22.60. As a long straddle, the maximum loss occurs if the stock price S is at the strike k of $22 at maturity. Taking long positions on both of these options was very cheap because the implied volatility is incredibly subdued -- with a mere IVR of 4. The current IV30 is 11.6, compared to the historical 20 day volatility of 31.6 and rolling year volatility of 34.5.
Cypress Semiconductors has agreed on a buyout offer from German chip maker Infineon Technologies for $23.85 per share. Before this deal can be completed, however, it has to be approved by regulators from both the U.S. and China. The deal is expected to close by the end of 2019 or early 2020, but heightened trade war tensions could interfere with the deal execution and final approval procedures. Cyrpess' CEO T.J. Rodgers, stated in an interview with CNBC: “Cypress makes some fairly exotic military stuff that could give CFIUS problems, and China, of course, is looking for ways to get even with us on the trade war thing.” Chinese approval of the merger is needed for the combined entity to trade there. Combined, they make the world’s number-one automotive chip maker, so losing the significant Chinese market would be catastrophic for either company. Cypress also has large exposure to China, like many others in the semiconductor space, so growing trade uncertainty is detrimental.
This straddle play benefits from movement away from the current price of roughly $22 -- which seems to be a likely consequence of brewing trade tensions.
JUST IN CASE YOU'RE WONDERING -- A SPY LONG STRADDLE PRE-BREXIT?A long straddle is a neutrally biased setup that is intended to take advantage of a large move in an underlying either to the put or call side and consists of an ATM long call and an ATM long put.
Given the fact that the market will either move up or down (potentially violently) in response to the outcome of the Brexit vote, you'd think that this would be an "ideal" setup for this type of binary event ... . But is it?
Let's look at the metrics of an example setup: a July 8th SPY 206 Long Straddle:
Probability of Profit: 46%
Max Profit: Undefined
Max Loss/Buying Power Effect: $694
Breakevens: 199.06/212.94
In short, you lose money on the setup if price stays between 199.06 and 212.94 and max loss occurs if price stays within the break evens at expiration. Conversely, you only make money on the setup if price goes above 213 (basically) or below 199. Not looking so hot now, is it?
In comparison, a 1 standard deviation long strangle, although cheaper to put on, has an even lower probability of profit and worse break even metrics. For example, a July 8th 197/216 SPY long strangle has a probability of profit of a mere 26% and break evens of 196 and 217 ... . In short, I would pass on the long strangle/long straddle plays here; in fact, you should probably pass on them virtually all the time ... . They're low probability plays and require fairly epic movement either way to make money (statistically, they're the least successful options strategy out there ... ).