Following one of the most violent moves in Sterling history it is worthwhile drawing lessons.

This is how one Matrix customer, a very experienced options trader who has followed me for 20 years, traded Brexit…on evidence based analysis and evidence based trading. In other words what is the most likely price action and what is the best way to trade it to maximise gain and protect capital.

The essence of this trade was that the more likely Remain result would cause the market to rally, or at least not fall by very much quickly. And more importantly, that implied levels of volatility were too high, even under a Brexit scenario where the price would fall sharply but not as sharply as implied volatility suggested.

THE TRADE:

A PUT SPREAD closing on the Friday after the vote where puts – right to sell –  are bought at two different levels. In this instance puts BOUGHT with a right to sell at 1.40 on Friday’s London close are more than paid for by the SALE of a much larger number of cheaper puts with the right to sell at 1.30 and 1.28.

  • If the market rallied then the profit would be the difference between the cost of the two sets of option.
  • If the market fell but no lower than 1.30 then profit would be that difference plus the profit on the short from 1.40.
  • Only if the market closed below 1.2785  would the trade go into a loss.

The key is identifying the right strike prices and the correct expiry based on evidence.

DETAILS:

Sold GBPUSD 100m 1.30 puts at 26 cents – $260,000
Sold GBPUSD 100m 1.28 puts at 25 cents – $250,000   Receive $510,000
Buy  GBPUSD   20m 1.40 puts at $1.825     -$365,000   Cost       $145,000

10:1 put spread, expiry Friday 24th June 4pm London time.

Trade done 6th-7th June, 17 days to expiry. Spot about 1.45. Volatility around 25%

Effectively net long.

If Remain and Sterling stays above 1.40 profit = $145,000.
If Brexit but above 1.30, then profit = $145,000 + profit from 20m short from 1.40.  Closed = $530,000

Total profit: $675,000

Potential loss: If Sterling closes below 1.30 then loss =  loss from £100m long 1.30 and £100m long 1.28.

RATIONALE:

Price Action:

BREXITPOLLGBPUSDwithmaplogox

The Re-GREXIT fractal showed Sterling testing but holding the 1.3850 low before the vote and then rallying to spike the 1.4750 high to above 1.50 but then falling slowing to new lows. This would presumably therefore be a Buy the Rumour Sell the Fact on a Remain result and therefore not trade below 1.30 by Friday’s close.

Volatility: On a Brexit, sterling would clearly fall more dramatically. But potentially how much?

GBPUSD Volatility

Historical volatility from BoE records going back 100 years show that a maximum daily shift would still not see Sterling close at or below $1.30 particularly in the face of likely Central Bank intervention and likely squaring up before the weekend.

LESSONS LEARNT:

Win or Lose – Always note the lessons learnt. As this customer highlighted:

  1. Time decay always kills volatility in the end
  2. Volatility will go higher than you can possibly imagine because people always do things at last moment and the market will squeeze them.
  3. Pick the right strikes, below maximum historical volatility. That is what really matters.
  4. Pick the right expiry, as short as possible after the event to minimize the chance of a sustained move
  5. Have confidence in evidence based research. Don’t delta hedge, move strikes for flat if you need to, by doing 2:1s and shifting down your point of risk.

It is better to be wrong and make money than be right but broke.  

-EM