While I'm certainly no expert on the politics of the United Kingdom, I do like to trade things that move.
As such, it's been hard not to follow the British Pound in recent weeks, which has seen a considerable boost in volatility due to recent confusion surrounding "Brexit."
As a brief reminder, the term "Brexit" refers to a referendum conducted in the United Kingdom back in June of 2016. At that time, roughly 51.9% of citizens in the United Kingdom voted in favor of withdrawing from the European Union (the Maastricht Treaty). The actual withdrawal in the aftermath of the referendum has proven to be a lot easier said than done.
Obviously, this development represented a big shift in the political and economic climate of Europe, which in turn catalyzed a reshuffling of perceptions for the greater economy of the region. Losing a big player like Britain (if it does end up happening), would be akin to an a major league sports team losing one of its franchise players - the future of the team (the trade bloc) gets cloudier.
Pulling up a historical chart of the British Pound/US Dollar exchange rate, one can see how the perceptions of various market participants in the foreign currency arena shifted immediately in the aftermath of “Brexit.” Within 3 months of the referendum, the British Pound had shed close to 16% of its value relative to the US Dollar, and was trading at the lowest point observed since the 1980s.
Fast-forwarding to the present, more than two years after the Brexit vote, the British Pound is once again under pressure. The Pound had rallied considerably during the start of 2018, but gave back back most of those gains in November/December due to continuing confusion over whether or not the United Kingdom will actually leave the European Union.
At this stage, it's literally anyone's guess as to what might happen next.
One realistic outcome may be that a second referendum is conducted, and that the United Kingdom remains in the Union. Assigning a probability of likelihood to that scenario isn’t easy though. A second referendum could also produce the same “leave” result as the first - putting additional pressure on politicians in Britain to execute the will of the people.
Given that the qualitative narrative of “Brexit” is about as clear as mud, the Market Measures team decided to examine more closely a quantitative analysis of Brexit, through the lens of the British Pound, to see if any patterns emerged (i.e. potential trading opportunities).
One complicating factor with this analysis is that the British Pound ETF (the FXB) is fairly illiquid, eliminating it as a suitable candidate for accessing exposure to the currency. Instead, the team decided to use data from the British Pound/US Dollar exchange rate futures, as well as the implied volatility metric for this product (BPVIX).
In short, this meant the team decided to pass over traditional equity options (due to illiquidity) and instead focus on foreign currency futures and associated futures options. On the show, the logic behind this choice is expanded upon, using SPY options as compared to /ES futures options.
As you can see in the two slides below, a backtest of a short strangle in /6B using futures options produced fairly attractive results, based on historical data. The first slide summarizes the average results using all instances from 2010 to present, while the second slide only includes instances in which IVR in /6B was elevated (above 50%):
An important distinction in the above data is how the win rate improved for instances in which implied volatility (IVR) was elevated. But it must also be noted that leverage in the futures market is greater, which means that risk exposure is elevated as compared to a traditional short strangle in FXB (for example).
With “Brexit” developments expected in the near future, it’s possible you don’t feel comfortable holding British Pound exposure. However, this particular trade structure (short strangle using futures options) may be a great candidate for “mock trading” (i.e. paper trading) with the intention of learning from the experience, and applying that knowledge to future opportunities.
No matter how you might decide to trade (or not to trade) the British Pound, it’s certainly worth noting the current value of the Pound versus the Dollar, and checking back in after the situation resolves itself. The difference between today’s value, and the future value, may be considerable.
We hope you’ll take the time to review the complete episode of Market Measures focusing on Brexit and the British Pound when your schedule allows. If you want to learn more about trading currency futures, we also recommend this previous blog post, as well as this past installment of Closing the Gap - Futures Edition.
If you have any questions about foreign currency futures or associated options, don’t hesitate to leave a message in the space below, or reach out directly to @tastytrade Twitter or send an email to firstname.lastname@example.org.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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