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Turning the vol up on trading FX

Published in Automated Trader Magazine Issue 34 Q3 2014

When it comes to equities, it seems fairly easy to define a beta for the market. Typically, we might think of S&P500, as a good approximation for what a typical equity investor's return might be. Indeed, there are many passive investors who follow funds which directly replicate S&P500. For bonds, we can do something similar if we pick an index such as Barclays Global Aggregate bond index.

Turning the vol up on trading FX

For currency markets however, there is no such obvious index which can easily represent the returns for a typical FX investor. Instead, we need to create proxies for generic versions of popular trading strategies which are commonly used in FX - such as trend, carry and value. Trend, as the name suggests, involves buying currencies which have positive momentum and selling those which have negative momentum. Carry involves buying high yielding currencies and funding those purchases through selling low yielding currencies. Essentially, investors are picking up a risk premium when they buy carry. The risk of carry trades is the drawdowns that occur during times of risk aversion.

Value based strategies tend to be very long term. They involve creating a value metric such as PPP (purchasing power parity) and using this to define whether a currency is over or undervalued. Currencies which are overvalued are sold and those which are undervalued are bought.

At the Thalesians, we have done a large amount of research on identifying what beta is in FX. We have shown that it is possible to replicate FX fund returns (such as the HFRX FX index), by using a mixture of carry and trend. This seems to suggest that it is indeed the case that as a group, FX funds do a large amount of carry and trend following based strategies, thus suggesting that these strategies can be considered as "beta" in FX.

HFRX FX index vs weighted mix of generic trend and carry

HFRX FX index vs weighted mix of generic trend and carry

Worst carry months, tend to see positive trend returns

Worst carry months, tend to see positive trend returns

EUR/USD short 1W ATM straddle returns vs. delta hedging returns (exc. transaction costs)

EUR/USD short 1W ATM straddle returns vs. delta hedging returns (exc. transaction costs)

Saeed Amen

Saeed Amen

Of course, running a portfolio of these various FX beta strategies seems like a better approach compared to running them in isolation to diversify risk. For example, during periods of risk aversion we have noted that carry traders (and more broadly stock markets) underperform. However, we might expect trend based strategies to outperform during these same periods.

However, once FX investors have successfully created a beta portfolio, the question is what other strategies can they look at? One possibility is to add an FX volatility strategy. FX vol markets are very liquid, and the approaches that investors typically use to trade equity vol can often be used in currency markets. Very often this involves selling volatility to extract the volatility risk premium. If we consider implied volatility, which is the volatility that is used to price options, it is often higher than where realised volatility ends up. The difference is essentially the volatility risk premium.

More simply, we can think of this difference as being necessary to compensate a trader for taking risk in selling insurance. To some extent we can see a parallel with carry traders, which also involve harvesting a (different) type of risk premium. Hence, the drawdowns that afflict carry during times of risk aversion can also impact strategies which sell volatility.

If we look at historical data, we note that Black Swan events, such as the collapse of Lehman Brothers, can see an explosion in volatility, resulting in a temporary negative volatility risk premium, which results in large drawdowns. Hence, if we are running a short volatility strategy, we need to be very careful in how we construct it.

Firstly, we need to consider which options we seek to sell. If we intend on selling heavily out-of-the-money options nakedly (without any sort of hedge), we could open ourselves up to very large drawdowns, which are big enough to exhaust all our capital.

We also need to think carefully about which tenors, we wish to sell. In my research, I have tried to focus on shorter dated options - mostly at-the-money (ATM) straddles - which have more gamma risk. Even if vol does jump, we might actually get opportunities to sell at higher levels of vol, because expiries are fairly close together. Also we can mitigate some of the effect from large directional spot moves on a short gamma position by delta hedging our exposure. We cannot totally eliminate drawdowns even if we delta hedge, particularly if spot oscillates rapidly around the strike.

If we are looking to sell longer dated options, we are essentially taking a short vega view, which could be more problematic during times of risk aversion. A more nuanced approach which I have seen vol traders take is doing a relative value volatility trade - harvesting risk premium in the front end whilst hedging against blow up risk by adopting a long position in the back end. Here the risk is more vol curve inversion. There is also the possibility of filtering volatility risk premium strategies.

Of course, there are also instruments such as volatility swaps in FX, which enable investors to directly capture the volatility risk premium without having to manage delta hedging. However, the transaction costs associated with these more exotic instruments are higher.

For FX investors wishing to branch out from the more traditional beta strategies of carry, trend and momentum, it is worth casting their gaze towards the FX vol trading strategies. However, when doing so, they need to be aware that these strategies need to be constructed very carefully to reduce the impact of the drawdowns during risk aversion.