Turn of the skew: FX options dealers balance fragile market

Macro hedge funds like Rokos Capital Management and Bridgewater may have profited from foreign exchange volatility during the second quarter, but for options dealers the market has become increasingly precarious.

Since US president Donald Trump’s explosive tariff policy announcement in April, positioning has been firmly geared towards US dollar weakening across G10 currencies. A July 11 research note from Bank of America says USD shorts had become one of the most crowded trades, with dollar sentiment and exposure at historic lows.

Strategists at HSBC had also compared the relentless dollar selling during the second quarter to “‘bubbly-like’ behaviour” that will eventually pop. 

For liquidity providers, a series of ‘mini-corrections’ since April has meant holding this position – and hedging it – can be tricky.

Sharp movements in spot and risk reversals – the pricing differential between puts and calls – often spell trouble for FX options market-makers managing their exposures.  Exotic parameters such as vega – the sensitivity to movements in volatility – and gamma, the rate of change of an option’s delta for a change in spot, can whip around wildly in yo-yoing markets.

Constant flip-flopping in skew may indicate clients seeking to exit their risk-on positions as quickly as they re-enter a risk-off trade

When risk reversals – also known as skew – are trading at a level where the demand for call or put options can easily flip, so too can the gamma profile of dealers.

Given how quickly the market can retrace after negative impacts stemming from unpredictable geopolitical events, dealers taking a cautious approach and covering their gamma exposure can easily find themselves over-hedged as volatility settles.

Take positioning in euro/US dollar FX options, where market sentiment shifted sharply in response to several headlines over the summer.

On June 12, the euro had appreciated to 1.16 against the dollar. One-month risk reversals – a measure of the volatility of upside calls struck out-of-the-money, typically at the 25-delta point, minus the volatility of puts at the same level on the downside – traded at 0.76, indicating a higher premium for calls on the pair.

After Israel launched an overnight attack on Iran, the dollar strengthened slightly to just below 1.15 as hedge funds took profit on their shorts. At the same time, skew nosedived.

By the time the US intervened with its strikes on Iran’s nuclear facilities on June 22, skew flipped to -0.53 in favour of euro puts as the dollar strengthened. A couple of days later, skew reverted to positive as geopolitical tensions calmed.

This aggressive repricing event in front-end volatility demonstrated that traders still hold the consensus view that the dollar can be a safe-haven currency when geopolitical risk occurs.