Signal du Jour - Long Vol in UUP

Who wants a cheap lottery ticket? (quoted in dollars, of course)

As the year winds down, the markets seem in a lull, lacking any significant catalysts. Following the Fed's announcement on inflation, which left the market in a state of contented euphoria, it appears that little can disrupt this tranquility.

However, the Bank of Japan (BOJ) did step out of the shadows, making a notable departure from its stance just a few weeks ago. The earlier talk of rising rates to combat inflation seems to have been shelved, as they're not quite ready to abandon their ultra-easy monetary policy. The markets took note, sending the Yen tumbling back to near 145 against the dollar.

This shift has implications for the US dollar—currencies, by their nature, trade in relation to one another. More than any other asset class, they are deeply interconnected. With several major economic announcements on the horizon and the Fed working to moderate market expectations of rate cuts next year, there's reason to believe that options on the dollar are currently undervalued.

So, today, we're not focusing on a short volatility trade. Instead, we're going long, adding a bit of variety to our portfolio.

Let’s dive into the details, but before that, if you haven’t subscribed yet, don’t miss our Christmas special and redeem your 50% discount on all of Sharpe Two’s content in 2024!

The Context

Venturing into currency trading as a retail trader can be a challenging endeavor. More often than not, you find yourself navigating amidst professional flows that are largely invisible to you. Much of the currency market operates Over The Counter (OTC), creating a layer of opacity for retail investors.

The dollar index, however, stands apart. It's a composite of all the major currencies traded against the dollar, and the UUP ETF offers investors direct exposure to this index. Since it's an aggregate and the dollar remains the world's primary reserve currency, the market dynamics are somewhat more transparent and easier to grasp. For instance, if the Fed signals a rate hike, the dollar typically strengthens, pushing UUP up. Conversely, if U.S. economic releases are underwhelming, suggesting a slowing economy and potential rate cuts, traders often sell off the dollar, leading to a dip in UUP.

Simple enough, right? But remember, our focus here isn't on predicting the direction of the asset. We're interested in its volatility.

Like any currency, the volatility in this asset class is traditionally lower than in equities or commodities. However, as the past two years have demonstrated, it can still undergo some dramatic movements.

As the Fed raised rates in 2022, the dollar index soared to new heights, accompanied by a rise in realized volatility. Market participants were scrambling to buy back dollars. It's interesting to note that this pattern fundamentally differs from the equities market, where realized volatility tends to increase when equities fall.

June 2023 presented another example. The market was uncertain about the Fed's strategy – 'higher for longer' or a rate hike by year's end? Unsure of which direction to lean, the default reaction was to buy dollars as a precaution. This action pushed the realized volatility back to around 8%, elevated but not excessively.

Last week's message from the Fed led to a sell-off in dollar positions and a decrease in the demand for 'insurance.' However, the mixed signals from other central banks and Fed members, coupled with key economic releases like this Thursday's GDP, suggest there might be a disconnect, especially in the short-term spectrum.

Now, let's delve into the data to see what it tells us.

The Signal And The Trade Methodology

To assess our market point of view, we compared the price of At-The-Money (ATM) straddles in UUP against their most recent subsequent realized movements, constructing a Z-score from this data.