Beware of currency markets when their chart patterns take on a linear appearance. Just when you think it is safe to enter a trade, the abyss opens up! OK so while the chart of the Euro firmly suggests that a downtrend is in place, beneath the scenes something is at play.
We would like you to bear in mind the motto of John Templeton “the best time to invest is at the point of maximum pessimism”. Getting straight to the point – the point of maximum pessimism towards the Euro is about now! Here is our evidence:
Net long positions in Euro futures are at record lows (actually net short positions are at record highs). This suggests that being short the Euro is now one of the world’s most crowded trades. Where is the marginal seller going to come from?
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Risk reversals are at levels similar to those which existed when the Euro blew out at the end of 2008. In essence risk reversals are the difference between the cost of calls and puts.
The greater the demand for an options contract, the greater its volatility and its price. A positive risk reversal means the volatility of calls is greater than the volatility of similar puts, which implies that more market participants are betting on a rise in the currency than on a drop, and vice versa if the risk reversal is negative.
This suggests that everyone who wants to be short Euros are already short.
Now the problem with the Euro, as we have been led to believe, is to do with the PIGS, most notably Greece. Yet the Greek CDS spread suggests that the eye of the storm may well have been broken. CDS spreads on PIGS have fallen dramatically over the last few days.
So we have enough evidence to make a contrary bet on the Euro. How do we execute this contrary play? Via the options market – by buying out-of-the-money calls on the Euro 12 months to expiry. So what happens if the Euro continues to fall? Well we don’t care too much, after all we have 12 months for this “call” to play out and run no risk of getting stopped out in the process!
