Should EUR/USD bears be worried by this FX option signal?
Nov 28 (Reuters) -Given their forward-looking nature and sensitivity to FX volatility, price movements in FX options can serve as a bellwether for market sentiment and the perceived outlook of a currency pair. Recent price action in the FX options market may raise concerns for EUR/USD bears.
Implied volatility gauges realised volatility expectations and is a key part of an FX option premium. Risk reversals gauge the direction in which volatility is most likely to increase by charging an implied volatility premium for strikes in that direction, versus a discount in the other.
EUR/USD implied volatility has held firmer levels over recent sessions to highlight the increased realised volatility in the spot market. Risk reversals were increasing implied volatility premiums for USD calls over puts (downside versus upside strikes), which spiked to new multi-month highs when EUR/USD slumped to new 2-year lows at $1.0332 after last week's weak Eurozone PMI data.
However, there's been a big retracement in this downside strike risk reversal premium since, especially for closer-to-maturity contracts. The benchmark 1-month expiry 25 delta risk reversal has halved to 0.55 from 1.1 premium for downside over upside strikes since last Friday, while 3-month risk reversals have reverted to 0.95 from 1.25 and 1-year to 1.35 from 1.45.
While this could rightly be interpreted as less perceived risk of more EUR/USD losses, certainly in the near term, it can also mean that there's less risk of related volatility if EUR/USD were to come back under pressure.
EUR/USD has already removed a swathe of barrier options from $1.0450-1.0350 that accelerated its initial slump and would need to threaten those at $1.0300 and below to reignite volatility - both realised and implied.
Traders are still buying the USD call Trump hedge, so aren't ruling out deeper EUR/USD declines, but further losses might now prove to be more of a grind than a rapid and volatile descent.
For more click on FXBUZ
1-3-12-month expiry EUR/USD FXO risk reversals https://tmsnrt.rs/418PM6S
Richard Pace is a Reuters market analyst. The views expressed are his own; Editing by Kevin Liffey
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