Euro Warnings from the Options Market

There are two developments in the options market for euro that one should think about even if one does not trade options.  We have often found that divergences between the spot and options generate important insight into market direction.  

The first development has to do with the pricing of puts and calls equidistant from the money.  These are called risk-reversals.  The standard benchmark is 3-month 25-delta options (recall a 50-delta is at the month, so a 25-delta is a bit out of the money).  

In option theory, put-call parity means that puts and calls equally away from the forward strike should trade for the same price.  To the extent they don't, it reflects a certain bias in the market.  

Bearish sentiment toward the euro was evident earlier this year as the premium the market was willing to pay for puts over calls widened to 3.5% by mid-May.  It is understandable as various participants bought euro puts.  This demand affected the skew.  

However, even though the euro has continued to decline, the risk-reversals, well, reversed.  From mid-May through the end of last week, the premium for puts trended lower.  As of July 20, the premium for puts fell below 1% to record the lowest premium since October 2010.  

Given that the euro was trending lower through the period, the reduced premium for euro puts seems to be an anomaly.   Yet its appears that what was happening was that many participants had amassed a large short euro position and were buying out of the money calls for protection.  Hence, the risk-reversals were moving in the opposite direction as spot.

However, the Bloomberg chart here shows that over the last couple of sessions, the premium for euro puts has begun rising again.  This seems to be a particularly bearish development.   It is as if the news stream has encouraged the euro bears to remove their hedges or insurance.  

This ties into the second development.  Three-month euro volatility had been trending lower since early June.  At the end of last week, it had fallen to below 9.5% to its lowest level since August 2008.  However, in the last two days, volatility has jumped and is now quoted above 11% and is at its highest level in over a month.  

At the same time that the news stream from the euro area has deteriorated, with signs of a  deeper and more protracted economic contraction; increased risk that Greece is squeezed out, that Spain needs a larger aid package; that Italy may need assistance as yields rise sharply, and fears that creditor nations are increasingly vulnerable (see Moody's warning late yesterday), and the euro slumps to levels not seen in a couple of years, volatility has risen.  The euro bears see less need for insurance just as the price of it has risen. 


Lastly, some option traders may be selling the risk-reversals--that is selling euro calls and using the proceeds to help finance the purchases of euro puts.  The 1.4% divergence seems modest compared with the potential for the euro to continue to fall.   Implied volatility also seems poised to trend higher as the fundamental pressure on the euro continues to drag it lower.