Trading GBP/USD Time Spreads

The coming days are crucial in determining the future of the British Pound versus the U.S. Dollar. Tomorrow is polling day in the UK and results will be out on Friday May 8th. Also on Friday, the much anticipated Non-Farm Payrolls (NFP) for April will be released. Expectations are for an additional 220,000 jobs following an extremely disappointing number, at 126,000, for the previous month of March. Another disappointing number on Friday would most probably mean that the Federal Reserve's interest rate hike will drift further away.

These important events will greatly affect GBP/USD’s trading direction and sensitivity. Below is this month’s GBP/USD trading chart showing an approximate 6% range between the low and high. Mid-April the pair has traded as low as 1.4580 and April 29 we saw highs at 1.5490. The pair is now trading around 1.5200.

Options are a great way to understand what investors are expecting in terms of future volatility. This is because the price of options depends on the marketplace's expectation of volatility. When there is fear and uncertainty in the market, investors turn to purchasing options for hedging purposes and are willing to pay as much as it takes to protect themselves. This escalates the price of the options and the expected volatility used to calculate these prices rises. Hence expected volatility is usually high at times of uncertainty.

GBP/USD options are currently indicating high volatility in the coming week, above 18%, and two week options are priced with volatility around 15%. The spreads between the volatilities from one week up to four weeks from now, are gradually tightening. This means that the expected volatility for this week is high and investors believe that once the UK election results are out, the UK's future economic picture will be much clearer. The near-term, high volatility is also factoring in the NFP data. Either way, the volatility curve makes sense as currently investor uncertainty is focused on this week.

A position that can be interesting for those wanting to speculate on these coming events is to sell a short-term option and buy a long-term option with the same strike rate. This strategy is called a “time spread” since you are selling and buying options on the same asset with different durations. Note that with time spreads, when the short-term option expires you remain with an open position on the longer term option. You will profit if the spreads between the volatilities in the options tighten, i.e., if the short-term volatility falls and the long-term volatility rises. The vice versa can also be traded if you believe that the spread between the different term options will widen, i.e. the short-term volatility rises and the long-term volatility falls.