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Thus a look at the historical data reveals that at least some hedging strategies can be revolutionised by the appropriate choice of contract.  It is not the case that options are a universal panacea; if the exposure were negative (for example if there was a future liability in the EM currency) then forwards would have been a better choice.

How about a trading strategy?

If there are anomalies and biases in the FX option market, it is natural to wonder whether they may be used to generate returns.  Investors like hedge funds, pension funds and insurance companies would be keen to know whether this is an area which could yield diversified alpha in a world of ultra-low yields. 

Above in Figure 4 we show the returns to a systematic straddle selling strategy in USDJPY.  The puts and the calls offset each other elegantly and the result is a surprisingly smooth and profitable series.  However, this includes only premium and payout – the marked-to-market variation would have added considerable volatility.  But nevertheless, it is clear that even this very simple strategy holds potential, and there are likely to be more to discover.

FX Options, The Elephant in the Room, How to, Generate, Significant Returns, Anomalies, Biases, FX Option Market,  Forex Strategy, fx traderFigure 4: Cumulative returns in % notional amount for 1W call selling in USDJPY          Source: Bloomberg and Commerzbank

Where did the elephant come from?

Can we discover where these very significant anomalies originate?  Let’s take a look at the payoff to a simple ATMF put or call FX option.

FX Options, The Elephant in the Room, How to, Generate, Significant Returns, Anomalies, Biases, FX Option Market,  Forex Strategy, fx traderFigure 5: Payoff to FX options and forward contracts

There are a number of features to the fairly complex diagram shown on Figure 5 and it is worth going through them carefully.

(1) Grey area surrounding spot rate at the start of the deal.  This represents where spot at expiry is most likely to be.  FX rates do not on average move to the forward rate; the long term existence of the carry trade proves this

(2) The solid normal distribution line represents the distribution of the spot throughout the life of the deal

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