Just how overbought is the USD? Well we could go around and price iPods, Big Macs, Colgate Toothpaste in different currencies, or we could look at how biased the financial crowd is? Specifically we could look at the price of options of various currencies. Enter the fabulous world of risk reversals.
Risk reversals are a representation of the market’s expectations on the direction of currencies. They are a fantastic means by which to identify how overbought or oversold a currency is over the medium term at least.
A risk reversal consists of a pair of options, a call and a put, on the same currency, with the same expiration (one month) and sensitivity to the underlying spot rate. Risk reversals are quoted in terms of the difference in volatility between the two options. Risk reversals are great for observing just how the market is positioned towards a currency (i.e. the degree to which it is bullish or bearish). A positive risk-reversal number implies that more market participants have already taken bullish positions. Of course the million dollar question is just where is the marginal buyer going to come from if the majority of the crowd has already taken bullish positions?
Right now Risk Reversals on the USD suggests that the crowd is heavily long the USD (short the Euro, CHF, GBP etc) and even more long the JPY.
If there is one thing that years of experience has taught us. One should always look to be a provider of liquidity to weak hands because weak hands are ultimately loosing hands. With extreme negative risk reversals of currencies against the USD it isn’t difficult to work out that weak hands are now heavily positioned long the Dollar. Well we will buy as many deep out of the money calls as we can on the Euro!
