As Fed meets, hedge funds buy ‘lottery’ FX options trades

Hedge funds are reloading their short dollar bets – with a few new twists – ahead of US Federal Reserve chairman Jerome Powell’s highly anticipated keynote speech at the central bank’s annual Jackson Hole conference on Friday, August 22.   

Garth Appelt, head of derivatives, FX and emerging markets macro trading at Mizuho Americas, says the bank is seeing renewed interest from hedge funds in euro/US dollar call options with far out-of-the-money strikes, which he describes as “lottery ticket” trades. The options, which have low premiums and allow for more leveraged bets, aim to profit if any unexpected signals come from the Fed chair that would lead to an acceleration in dollar weakness.

“The way that they [hedge funds] are structuring them is in low-delta form. They are not big directional trades and a lot of it is date specific, such as post-Jackson Hole or the September Federal Reserve policy meeting,” says Appelt.

“Normally, when people are searching around for lottery tickets, that is the beginning of them trying to step their toes in because they don’t want to miss if it starts to move.”

Hedge funds have been putting on this trade in a one-touch or digital structure, with payouts expected if EUR/USD spot jumps to between 1.22 and 1.25 over the next six months, he adds. As of August 21, EUR/USD spot was trading at 1.16.

A lower dollar is still the main thread of the market, but it’s probably a bit crowded

Samy Bellady, Natixis

Butterfly spreads have been another popular strategy in the lead-up to the Jackson Hole conference, according to Appelt. These options packages pay off if spot remains within a certain range or volatility decreases. The strategy has become more attractive following a recent fall in volatility levels, says Appelt.

“You might buy a 1.20 call and then sell two times notional of a 1.23 call, and then you might buy a 1.24 strike as a wing-type option to protect you just in case it really blows through. But that, again, is a cheapening way to participate in the upside,” he adds.

Spells of dollar strength over the summer in response to better-than-expected trade deals and wide interest rate differentials have made hedge funds wary of betting on a one-way move.   

Some hedge funds have added to call positions that will pay off if spot hits 1.19 following the outcome of the Jackson Hole conference. However, the nature of the trades suggests the funds have become more cautious about going all in to short the dollar over the summer.

But the currency’s recovery in July was short-lived following disappointing employment data, sparking expectations of faster and deeper interest rate cuts. A more dovish tone from Powell at the Fed meeting could, therefore, accelerate dollar weakness on the prospect of narrowing interest rate differentials with Europe.

Three-month EUR/USD risk reversals – which measure 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 – have trended downwards from 0.75 on August 6 to 0.59 as of August 21 but still signal a higher premium for calls.

“A lower dollar is still the main thread of the market, but it’s probably a bit crowded,” says Samy Bellady, global head of FX options trading at Natixis. “When an event happens, we can expect a correction that can be quite important, depending on the event. And as we look at the near future, there are a lot of reasons to believe that it’s something we probably will see again.”

Bellady says a combination of low realised volatility and muted spot moves over the summer has contributed to a build-up of short-dollar positions.

However, there are concerns that in the shorter dates unexpected headlines can cause sudden, sharp movements. On July 16, EUR/USD rose 1.5% in a matter of minutes following reports that US president Donald Trump was preparing to fire Powell, only to drop back down after the White House quashed the rumours.

Hedge funds that jumped on the move higher only to then be burnt on the immediate mean reversion fear such sharp moves could cause outright vanilla options trades to be stopped out.

In addition to butterfly structures, Bellady says some of Natixis’s clients have opted for a long call spread strategy, which allows them to express their underlying short view with some downside protection. 

The strategy involves purchasing an at-the-money strike and selling a higher strike to offset the cost with the same notional – for example, buying a three-month call option with a high delta strike of 1.19 and selling an equivalent far out-of-the-money call option with a strike of 1.23. This enables traders to profit from a narrow range-bound market or to hedge against a moderate price movement in either direction.

With call options trading at a much higher premium, Bellady says the structure could be made even cheaper by increasing the notional and the strike of the second leg. The main risk in the trade is that the euro strengthens too much.

“You’re selling the risk reversal, which is high, with the same global picture of a short dollar exposure. Of course, you have the risk that the move is stronger than you expect. Then this position will end up losing money, but that’s the risk of increasing the second leg,” he says.

Editing by Joe Parsons and Kris Devasabi