UK budget gives sterling options traders a wild ride

Sterling foreign exchange options markets remain on edge after a wild ride last week, which saw implied volatility and trading volumes surge to multi-year highs, fuelled partly by rehedging of exotic positions.

Traders rushed to buy put options after UK chancellor Kwasi Kwarteng announced a surprise £45 billion of tax cuts in the so-called mini budget on September 23, causing the sterling/US dollar rate to slide more than 7% within 24 hours. In the following days, demand for options pushed implied volatility – a key input in options pricing – to highs not seen since the start of the Covid-19 pandemic in certain tenors.

“The way the market was trading on Monday (September 26) was very reminiscent of the financial crisis. It certainly felt like we were under the shadows of the financial crisis – the reduced level of liquidity in the market and the broad dislocation across G10,” says Tim Joyce, head of FX options trading for Europe, the Middle East and Africa at Credit Suisse.

At their peak, one-year at-the-money cable options hit 16.34 vols, versus 16.11 during March 2020, according to Bloomberg data. Six-month at-the-money options reached 18.09 vols, just short of the 18.27 level seen during Covid.

The Bank of England’s September 28 intervention in UK government bond markets failed to calm the currency, which remained volatile as spot GBP/USD rose back up, eventually returning to levels seen before the chancellor’s budget. Implied volatility remained above 14 for both tenors as of October 5. Implied volatility before the budget rested around 11 for both options.

For the week beginning September 26, vanilla GBP/USD options volumes hit $48.4 billion notional, the most active week since Brexit negotiations roiled options markets in 2019, according to trades reported to the Depository Trust and Clearing Corporation’s swap data repository, which includes trades involving at least one US-regulated counterparty.

The $29.3 billion notional volumes of vanilla GBP/USD put option volumes outpaced the Brexit period’s most active week. GBP/USD spot sat at 1.12 at 8am UK time before Kwarteng’s speech, and the announcement led to a surge of puts concentrated on strikes between 1.07 and 1.09 in the days following. Some traders executed put options with strike prices below parity, though the lowest spot cable reached was 1.04 in Asia hours on September 26.

Some investors had previously bought exotic structures that included downside barriers, which if spot crosses these, causes the option to extinguish with no payout. Henry Drysdale, head of currency options trading at NatWest Markets, says barrier positions set between 1.10 and 1.05 exacerbated the spike in implied volatility, when dealers were forced to buy back hedges of downside barrier positions.

“Some of the vol the market-makers thought they had was against barriers. They’d sold vanilla hedges against exotic positions, and as soon as those exotic barriers knocked out, they were knocked out of the vol and left with vanilla hedges. That causes a big spike up in vol when they bought back vol, and obviously the movement in spot was significant enough to cause a big spike in vol as well,” he says.

By mid-week, Drysdale says hedge funds that had long volatility positions were taking profit. The whipsawing currency left others on the losing side if they had anticipated spot would continue to move lower. When spot reversed its downward trend after the central bank’s intervention, those that were short sterling lost out.

“The Bank of England took some of the stress out of the market, so vols started to sell off. It has been extremely volatile since, so trying to sit short gamma has probably been quite painful,” says Credit Suisse’s Joyce, referring to volatility selling positions.

“Some people probably got short sterling at quite bad levels. I can imagine that some people who were buying downside sterling on Wednesday (September 28) have already closed that out because they’ve potentially been stopped out of the position already,” Joyce adds.

Matthew Gittins, head of trading and sales at agency FX broker Spectra FX Solutions, says the bid-offer spreads widened out considerably as the turmoil continued.

“On Friday morning (September 23), we were able to transact in normal sizes with slightly higher transaction costs, but by Friday evening it was difficult to get risk transfer prices from traditional LPs. By Monday, there was some appetite back but at prohibitive spreads. Normally, a one-month option would trade at about 0.2 of a vol wide and on Tuesday (September 27) it’s trading at about 1.2,” he says.

But despite the widening, NatWest’s Drysdale said the market still functioned through this period. “There were still prices throughout the day – much wider prices, but there were prices,” he says.

Additional reporting by Joe Parsons