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Hedge funds may be profiting significantly from foreign exchange volatility, but for options dealers it’s become an increasingly fragile market. Market positioning since US president Donald Trump’s explosive tariff policy announcement in April has been firmly geared towards US dollar weakening across G10 currencies. According to a July 11 research note from Bank of America, USD shorts has become one of the most crowded trades, with dollar sentiment and exposure at historical lows. And strategists from HSBC have compared the relentless dollar selling to “bubble-like behaviour” that will eventually pop. But for liquidity providers, the series of ‘mini-corrections’ that the market has seen since April has made holding this position, and hedging it, sometimes troublesome. Sharp movements in spot and skew often create issues for FX options market-makers managing their vega and gamma exposures – sensitivity to movements in volatility, and the rate of change of an option’s delta for a change in spot, respectively. When skew is trading at a level where the demand for call or put options can easily flip, it creates a fairly weak gamma profile for dealers. They don’t want to find themselves over-hedging to cover their gamma exposure as volatility comes down, given how quickly the market can retrace – especially when most of the market movements are coming from unpredictable geopolitical events rather than more predictable data releases. Take positioning in euro/US dollar FX options as an example. On June 12, the euro had appreciated to 1.16 against the dollar, and one-month risk reversals – a measure of the volatility of upside calls struck out-of-the-money, typically at the 25-delta point, minus the volatility of puts at the same level on the downside – traded at 0.76, indicating a preference for calls on the pair. After Israel launched an attack on Iran overnight, the dollar strengthened slightly to just below 1.15 as hedge funds took profit on their shorts. Risk reversals, otherwise known as skew, began to dip negative. By the time the US intervened with its strikes on Iran’s nuclear facilities on June 22, skew flipped to -0.53 in favour of euro puts as the dollar strengthened. A couple of days later, skew reverted to positive as geopolitical tensions calmed. But since July, skew has declined as the dollar strengthened. On July 14, the US Dollar Index (DXY) closed above its 21-day average for the third day in a row for the first time since May, and by July 16, one-month risk reversals hit -0.17. Things then got rocky. Later that day, when reports emerged that the US president was preparing to fire the head of the Federal Reserve, EUR/USD spot quickly jumped 1.31% in an hour, and skew jumped back to 0.26. While spot retraced quickly even before Trump poured cold water on the reports, skew remained positive at 0.07 as of July 17. What this means is that, unfortunately for options traders, who usually revel in volatility, they will have to remain on their toes all summer long.
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