Sterling option volatility spikes on Brexit deal news

The sterling market is braced for more volatility after banks were caught off guard on Friday when foreign exchange options trading surged as traders piled into upside bets on the UK currency.

With notional volumes of sterling-US dollar options hitting $23.5 billion, Friday made for a “crazy” day of trading, says one London trader at an interdealer broker. It was the largest single day of options trading in the pair since at least the start of 2018, according to data from the Depository Trust & Clearing Corporation.

Sterling rose nearly 4% against the dollar late last week as traders reacted to progress in negotiations between the UK and European Union in advance of an October 31 deadline for Brexit. Volatility in sterling-US dollar options – a key input in options pricing – also climbed with one-week contract volatility reaching 17.3 at midday on Friday, up from 8.9 at midday on Thursday. Options at other tenors saw similar increases.

“The consensus was very much an extension of the deadline followed by elections in the UK, so a lot of previous assumptions had to be questioned,” says Julian Weiss, head of foreign exchange options for Europe, the Middle East and Africa at Nomura.

Option skew, the difference between the volatility of call and put options, spiked at 1.8 at 11:00am on Friday for one-week, 25 delta contracts, up from 0.57 at 11:00am on Thursday. Skew flipped back on Monday, with the so-called risk reversals falling below one, meaning that put options have become more expensive relative to call options.

“Skew has come off from Friday’s highs, as dealers are not only worried about another explosive move higher but also a total retracement of last week’s move,” Weiss says.

The downward move comes after weekend reports that a deal may be further out of reach than previously suggested. Sterling was trading at 1.26 on Tuesday afternoon in London. 

Petr Krpata, chief forex and interest rate strategist for Europe, the Middle East and Africa at ING, wrote in a note on Monday that “with the market possibly getting ahead of itself, the pound is now vulnerable to a selloff should the talks break down again.”

One-week volatility remained high on Monday afternoon in London at 16.6. Weiss says the Brexit situation makes for a market in “maximum uncertainty”, a familiar condition to sterling traders throughout the Brexit negotiations.

Friday’s sterling-US dollar options volumes were more than double the $9 billion in notional traded on Thursday, which itself was up from the $4.7 billion average for the three days prior. A previous high water mark was the $14.8 billion in notional traded at the end of July amid increased concerns over a no-deal Brexit.

Krpata wrote that large sterling gains “have in part been caused by meaningful short speculative positioning, exaggerating the effect of the news flow”.

Earlier in the week option strikes were mostly clustered around 1.25. But on Friday the number of call trades increased, with sizable bets above 1.30.