LONDON, Dec 10 ― Expectations of a Conservative Party victory in Thursday's UK election have sent the pound rocketing ― but some investors are hedging themselves against a surprise outcome that could deal the currency a mighty blow.
Since early November, sterling has rallied 2 per cent against the dollar, hitting a seven-month high of US$1.3180 (RM5.4834), while against the euro it reached a 2-1/2-year high of 83.94 pence, up 2.7 per cent in the past month.
Opinion polls put the ruling Conservatives on course for a parliamentary majority, enabling Brexit to go ahead by the end of January, 3-1/2 years after the referendum on whether Britain should leave the European Union.
But options show there's clearly some nervousness running through the market. Yesterday, one-week sterling risk reversals, a measure of sentiment and positioning in option markets, traded at their most bearish since June 2017.
What that means is that the implied volatility premium for sterling “puts” over “calls” for the period straddling the election has risen sharply.
It's unusual for the option premium to protect against a currency setback to rise at the same time as the currency rallies in the spot market. But that may have something to do with opinion polls' patchy track record of predicting the outcomes of recent UK elections.
While sterling puts were in demand before the 2017 election, the currency's spot market gains were nowhere as remarkable as in the run-up to this vote.
The recent moves have taken the premium for one-week puts over calls ― essentially options giving holders the right to sell or buy the pound respectively ― from around 0 per cent to more than 3 per cent implied volatility, highs not seen since before the 2017 election.
Risk reversals out to two-month maturities also show the cost of protecting against sterling weakness has risen to levels last seen in April.
“It shows investors are buying spot but also low-delta sterling puts just on the off-chance that if we get a surprise they are protected. In other words you are seeing people hedge for a downside scenario,” Peter Kinsella, head of global FX at UBP said, adding it was no longer cheap to hedge downside risks.
A low-delta put refers to an option to sell at a “strike” price far below current levels.
With one-week implied volatility doubling since Friday and implied volatility on sterling puts above 3 per cent, the premium on a US$1.29 strike option has shot up to around 1.7 per cent.
Some option sellers had jacked up prices “because they don't want to be short downside strikes going into the election,” Kinsella added.
Some recent sterling gains are down to investors slashing short pound positions ― from US$7.8 billion in August to US$2.4 billion this month.
But some opinion polls still suggest it's too close to call a parliamentary majority for the Conservatives, with vast numbers of undecided voters and calls for tactical voting.
A Labour government, even one formed with support from smaller parties, may send sterling to the low US$1.20s, traders reckon.
JPMorgan forecasts sterling at US$1.34 by year-end but says “the story is not over”.
“There are a lot of scenarios and even a no-deal Brexit is not completely out of the picture,” JPMorgan strategist Luis Oganes said, adding that this entailed maintaining “some degree of cautiousness, and we're certainly not going all out on the currency.” ― Reuters
