Traders analyze the FX derivatives market in order to identify relatively cheap and expensive aspects of the volatility surface. This analysis is then used to position trading books and generate trade ideas for clients. The FX derivatives market has many moving parts and there are a correspondingly large number of ways in which it can be investigated.
The simplest FX derivatives analysis involves combining a short-dated vanilla option payoff with its premium to calculate its breakeven. Assuming the option is left unhedged until maturity, if spot moves beyond the breakeven point, the trade will make money. This breakeven point can be compared with expectations of spot movement to determine whether the option is cheap or expensive.
For a single vanilla option, the premium (expressed in CCY2 pips) is added onto (for a call option) or taken away from (for a put option) the strike level to determine the breakeven. For example, if current USD/JPY spot is 95.00 and the premium on a 3mth 100.00 USD call/JPY put option is 400 JPY pips, the breakeven on the option is 104.00. This is shown in Exhibit 17.1.
As the strike is moved higher, the premium decreases but the breakeven moves further away, as shown in Exhibit 17.2.
For a short-dated ATM straddle, ...