Euro-to-Dollar Options Market Suggests Traders are Bracing for a Correction

© kasto, Adobe Stock

This week's shift in EUR/USD risk-reversals favours a lower Euro and suggests that markets are now bracing for an extension of February's fall in the underlying exchange rate.

Currency traders are bracing for a downward correction in the Euro-to-Dollar exchange rate, according to strategists at retail trading firm Swissquote, who are flagging a sudden and bearish shift in derivatives market pricing.

The Euro was buoyed in 2017 and the New Year by a stronger economic recovery and expectations that the European Central Bank will soon normalise its monetary policy.

The EUR/USD exchange rate was also aided by a weaker US Dollar, which had helped it to rise by nearly 5% at its zenith in January.

However, in February, the single currency has lacked the momentum required to mount another challenge of its January highs and speculation of a possible US Dollar rebound is now growing.

This leaves the outlook for the EUR/USD rate a touch dimmer than it was just a few weeks ago, when the common currency's earlier gains had seen analysts falling over themselves to upgrade their first-quarter and year-end forecasts.

“Looking at the option market, one can notice that the price of put options has increased steadily since January 2nd, especially for shortest term maturities, which tends to suggest that market participants are bracing for a correction in EUR/USD,” says Arnaud Masset, a strategist at Swissquote.

Masset is flagging rising premiums paid by traders for EUR/USD Sell options, which are complex derivatives that provide investors with the option to sell EUR/USD at levels different to those prevailing in the underlying currency market.

Traders will pay a large “premium”, or price, to buy options that give them the ability to sell EUR/USD at a rate that is either above the current market price, or likely to be above the market price as the option’s maturity date approaches.

“The 1-week 25-delta risk-reversal measure hit -0.6375% yesterday, while the 1-month one stood at -0.7725%, compared to 0.22% and 0.2625% on February 2nd, respectively,” notes Masset.

The “25-delta risk-reversal” is a measure volatility in options to buy and sell the EUR/USD exchange rate.

When the risk reversal is quoted as a positive percentage value it indicates that options to Buy EUR/USD are more expensive than options to Sell EUR/USD, implying an assumption by the market that the Euro-to-Dollar rate will rise over the coming period.

Conversely, when the risk reversal is quoted as a negative percentage number it suggests that Sell options are more expensive than Buy options, implying an assumption by the market that the EUR/USD rate will fall over the coming period.

When risk reversal quotes suddenly shift from positive percentage values, like those in the early days of February, to negative percentage values like those on Tuesday, it implies a sudden change of heart by the market on the most likely direction of the exchange rate in the relevant period.

“For now, the sharp increase of put prices has not affected the spot market. However, this price divergence tends to suggest that investors are positioning themselves for a stronger US dollar,” says Masset.

This latest shift in EUR/USD risk reversals suggest that markets are now expecting a fall in the underlying exchange rate.

“Indeed, the next couple of months will be key as the Fed, which has a new boss, Jerome Powell, is expected to lift interest rate in March. In addition. Rising inflation pressure in the US has forced investors to revise their rate hike expectations to the upside,” Masset adds.

At the heart of the sudden shift in sentiment toward the Euro-to-Dollar rate is a recent increase in volatility across global stock markets, brought on by fears of a looming rise in global inflation and global interest rates.

These inflation fears were brought about by a strong January jobs report from the US, which prompted some observers to float the idea that the Federal Reserve may be less patient about raising rates in 2018 than it has in prior years.

This sent the VIX index, which is a “fear gauge” that measures volatility on the S&P 500 stock market index, surging by more than 150% in a single session. It’s largest single day rise on record.

Stock markets duly collapsed and the US Dollar has risen notably, snapping a January long losing streak, as traders dumped risk currencies and flocked to the safety of the greenback.

Some have suggested that this trend may continue for a while yet, an expectation that would support Swissquote’s view that the EUR/USD rate might see further downside in the weeks ahead.

The EUR/USD rate was quoted 0.28% higher at 1.2340 during noon trading Tuesday, which puts it 2.99% higher for the year to date but some way below its 2018 peak of 1.2537.

Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here.