Markets Expect UK Election Result to Cause Huge Spike in GBP Volatility
The currency markets are anticipating a huge sterling (GBP) volatility spike in the immediate aftermath of the election vote.
There is plenty of market chit-chat over the concerns and uncertainty around the UK elections. Neither Cameron nor Miliband are reining and an outright victory is becoming less likely. Trying to predict this election is one thing, but putting your money on it is another.
Options are a hot topic leading up to the UK election, because they are used to trade volatility as well as direction, investors are entering option trades to protect their existing Sterling positions or to benefit from changes in volatility. Since the price of options depends on the marketplace's expectation of volatility, it's possible to analyze options over different duration's to build a bigger picture of market consensus.
When analyzing GBP/USD option prices, an alarming volatility spike emerges; the market expects volatility until the week after the election result (1-month from today) to be higher than the volatility up until polling day and also, higher than several weeks after the elections. The spike in 1-month vol can be observed in the blue line of the chart below.
We can be confident this is significant and related to the UK elections because, besides EUR/GBP, no other pair is showing a 1-month spike of this magnitude. For example, see the EUR/USD volatility changes in the chart's orange line of the chart, it is much smoother.
What does this mean? When an outcome is uncertain, markets become more volatile. In this case, consensus is that the election result is unclear and a situation, such as a hung-parliament, is being priced in. In the longer term, once election results are out and their implications are known, investors are expecting more price stability.
How to trade it? If uncertainty persists leading up to the election and subsequently the result causes instability in the UK's longer term economic outlook, such as a threat of the UK leaving the EU, the volatility of GBP/USD in the longer term (3-months) may catch-up with the 1-month volatility. Buying options allows traders to benefit from increasing volatility. Assuming the GBP will weaken, we present a trade idea involving Put options on the GBP.
Trade example: Buy a 3-month at-the-money GBP/USD Put option for the amount of 10,000 GBP. The option costs 321 USD (215 GBP) - This is your maximum risk in the trade. The image below shows how the trade is set-up.
The scenario chart and table below shows the option's payout at expiry on July 16th, 2015, over a range of market rates. The break-even point is 1.4583 and below this a profit is made with 100% return at 1.4262.