Hedge funds pile into renminbi FX options

Hedge funds have cashed in on US dollar/renminbi moves in recent weeks, sending traded options volumes to at least three-year highs amid a surge in volatility in the recently calm pair.

Spot USD/CNY jumped 7% to 6.79 between the April 18 and May 13 closing prices – the largest 20-day spot price change in years – on the back of a rising US dollar and declining economic expectations in China. A drop in FX volatility supply helped push vol higher, attracting hedge funds who have looked to options-based strategies such as call spreads and reverse knock-outs (RKOs) to take advantage of the moves.

“It's been one of the more profitable trades of the year,” says Adrian Averre, head of FX derivatives electronic trading at BNP Paribas. “A lot of people managed to get the position on and did rather well.”

Unlike outright call options, where a fund would pay for unlimited upside, positions established through call spreads and RKOs limit potential gains but require less funding than outright options. In call spreads, for instance, a fund may buy a three-month call option that pays out if USD/CNH moves above 6.7, and sell a call option with a higher strike to help fund the position. The pairing limits a fund’s gains to spot moves below the sold strike. Reverse knock-outs pay out only if spot falls within a particular range.

Matthew Gittins, head of trading and sales at agency foreign exchange broker Spectra FX Solutions, says most of the trades he saw involved these types of structures.

“These are very, very common in China because it is a managed pair, and you can have a reasonable idea of where the PBOC [People’s Bank of China] will get uncomfortable with either the speed or the magnitude of the move,” says Gittins.

Just how profitable depends on the entry and exit points, as well as the amount of leverage used. But Gittins estimates funds could have netted a 3% return by running what amounted to a low-risk strategy.

“While that doesn’t sound a lot, as opposed to a cash or a delta-one position, your loss has always been limited at any point to something like 0.3 or 0.4%. There were no pullbacks – you literally never had to worry about cutting out of the position, and that’s very unusual.”

Lack of guidance

The fact that the central bank did not intervene as much as it could have caught some by surprise, and suggested Chinese authorities were content with some level of depreciation.

“Their absence has created a dynamic the market hasn’t seen for a few years now, and meant the market is largely trading on its own without any meaningful guidance from the Chinese authorities,” says Ruchir Sharma, head of Asia-Pacific FX trading at Credit Suisse. “That’s leading to a lot more volatility, and as a consequence, a tremendous amount of volume is going through.”

Implied volatility on one-month at-the-money options peaked at 7.99 on May 9, according to Bloomberg data, after trending downward since late 2020. Three-month, six-month, and one-year options saw similar spikes that brought the contracts to multi-year highs.

Volatility has since fallen, as spot has retraced to 6.7 on May 27.

Trading volumes started to grow the week of April 18, when the spot price of the previously lacklustre currency pair began to move higher and conform to a broader trend of an appreciating US dollar, in part due to interest rate hikes. The Chinese currency had resisted the pressure experienced by other emerging market currencies, perhaps partly due to buying pressure after Russia’s invasion of Ukraine, which sent the renminbi up against the euro.

“People were ignoring USD/CNH, largely because of what was happening in EUR/CNH,” says Sharma.

The market is largely trading on its own without any meaningful guidance from the Chinese authorities

Ruchir Sharma, Credit Suisse

When that flow disappeared and prolonged Covid-19 induced lockdowns in China continued to take an economic toll, the renminbi slid against both the euro and US dollar. Hedge funds took notice.

By the end of that first week of trading, a record-breaking $74.5 billion in vanilla option notional had hit the market, according to trades reported to the Depository Trust & Clearing Corporation’s swap data repository, which captures trades involving at least one US counterparty. The next week beginning April 25, $73.6 billion in vanilla option notional traded, more than three times the average of $22.5 billion notional that traded in previous weeks since 2019.

“We haven’t seen that level of engagement from fast money [hedge funds] in the CNH market for a long time, particularly on CNH devaluation, because it’s been such a big money-losing trade for fast money,” says Sharma.

At the same time, Chinese corporates, which typically serve as a source of option supply, stepped back and left dealers without a natural option seller to offset the slew of buying from hedge fund clients. The imbalance helped push volatility higher.

Sharma says dealer positioning meant that once spot exceeded 6.5 – as it did the end of that first week – they were forced to hedge by buying dollars against the renminbi, which helped accelerate the moves upward. The need subsided when spot crossed 6.7, aided by some funds unwinding trades.

Another FX options trader at an agency broker says clients began taking positions off as spot neared what would be its peak.

“The closer we got, the less conviction people had, so we only saw people rolling up or putting on multiple new trades for the 6.50 to 6.70 range. Then the minute we started to get up to above 6.8, most of our clients started to take stuff off,” the trader says.

Even though market activity has cooled, some trades reported to the DTCC remain elevated, which traders say may be due to hedge funds unwinding trades.

Out-of-the-money call options remain more expensive than equivalent put options, Bloomberg data shows, as so-called risk reversals point to larger demand for upside optionality.

“We haven’t seen a lot of option premiums spent on the expectation that USD/CNH will move lower, back to 6.55 or so. The balance of positions is certainly that it will still move back higher, but that position is much reduced compared to early May,” says Gittins.