Forex Flash: Lessons from CHF and JPY options markets - Societe Generale

Sebastien Galy of Societe Generale notes that when the SNB established the EUR/CHF floor, the implied volatility collapsed dramatically because the market expected the currency pair to remain range-bound.

However, shortly afterwards, he comments that the demand for butterflies skyrocketed. He writes, “Going long a butterfly secures a rent when the realised volatility is very low (short gamma means long theta). But the range has to break or become larger sooner or later, and at that moment, it is much better to have a long gamma safety net. That is why the option market bought large amounts of tail risk (hedging the wide range – long strangle) in selling vol at the current levels (monetizing the narrow range – short straddle). Relatively speaking, this uncertainty about a change in range behaviour could apply to a currency war.

Further, he notes that another illustration is the latest USD/JPY uptrend since last November, which was very volatile. He writes, “This fits the currency war case more closely, since it follows the loud call of Japanese officials for a weaker yen.” He continues to explain that interestingly, implied vols increased less than realised vols despite massive buying flows in USD/JPY options. Moreover, the USD/JPY vol is already falling. This is because of the mechanical effect mentioned above: the spot is now stabilising, as shown by the abruptly falling realised volatility.