Implied volatility in the China NDF market has fallen steadily since the end of last year, with the fall accelerating towards the end of February as the supply of options coming from corporate hedgers and the structured products has outweighed demand for volatility. “There’s been a big drop off in the hedge fund type option buying, while the structured supply has continued,” said the Hong Kong-based head of derivatives trading of a European bank.
Demand for USDCNY options typically comes from two camps – those looking to profit from the Chinese renminbi appreciation story by buying dollar puts and those, who are in the minority, that have the view that China is a bubble waiting to burst and purchase CNY puts/dollar calls to express this view.
Towards the end of last year, the china blow-up merchants, started to gain the upper hand and their flows started to outweigh structured supply but this trend reversed as the New Year began. Realised volatility in the spot market became stabilised, which dampened activity in the market.
“People became less excited by the RMB appreciation story and combined with the fact that all eyes were on Europe, with China appearing to be muddling through means the demand for China puts as ‘blow up protection’ also dissipated,” said the trader.
However, the increase in supply of volatility is seen as a seasonal trend that could be reaching its peak soon.
“Generally that flow tends to hit a peak early on in the year, with the majority of flow seen in January and February,” said the trader.
This is due to aggressive marketing from many banks at the start of the year in the structured product end of the market and the fact that banks do the most business in the first quarter of the year anyway.
“What we’ve seen in the past is that typically around the end of February there is a lot of selling but then vols soon stabilise thereafter,” said the trader.
Buying opportunity
Traders say that USDCNY volatility may now present a good buying opportunity for a number of reasons. Firstly, if the eurozone crisis gradually moves towards being resolved people may start to look for other things – one of which will be China. For example the subject of the Chinese bubble could garner more attention and lead people to buying China puts again.
Across most markets implied volatility looks expensive because of the supply and demand imbalance, but China is seen as the exception where the implied volatility doesn’t look expensive.
The European bank recommends going long USDCNY vols as a spread against volatility in other currency where vols are rich, as a relative value trade.