On May 7th the UK elections will be held, the latest poll results (23/24 April) show a neck – and – neck race between Cameron (Conservatives) and Miliband (Labour), 33% versus 35%.

History has shown that the Pound versus the Dollar displays quite some volatility before and after elections.

Source: Telegraph

The chart above shows in light blue the change in GBP/USD before the election and in dark blue the change in GBP/USD after the election for the past 5 elections from 1992 to 2010. Only on one occasion, May 1997, the currency pair remained stable.

Obviously there will be a plethora of arguments for what direction the Pound will be heading. However, there will be also people expecting the proverbial non-event, resulting in a rangebound market just like as what happened in 1997.

The GBP – USD relationship has been very steady in the past three months as shown below:

For those, trying to monetise on a rangebound currency pair, it could be interesting setting up a time spread in options. By selling the May 22nd expiry 1.51 calls and buying the June 22nd expiry 1.51 calls one can generate a decent profit when the market stays rangebound. Currently one can set up this strategy at 0.65 – 0.70. At expiry of the May options the combination will, at 1.51 in the underlying, have a value of 1.95, a profit of around 1.25. When just setting up the structure and not performing any (gamma) hedges, the P&L distribution will look as follows:

As I emphasise in my book “How to Calculate Options Prices and Their Greeks” you should approach options in a 4 dimensional way and not in the 2 dimensional way one usually finds in books or the internet. Since only 3 dimensions can be presented in one chart, I have left the volatility component out of the distribution, assuming it will be stable in the coming weeks (the combination has a short time to maturity and hence the impact of vega is not that large). Thus the P&L distribution chart now reflects profit versus time versus underlying level.

As you can see, the structure can never lose more than the initial premium being paid, however already at 1.47 and 1.55 the combination will start to yield a loss. So actually it shouldn’t move too much! The more experienced traders can apply a hedging strategy on the back of the gamma of the position. By hedging the gamma you can make sure, if there are not too many retracements (because they will consume profits), that when the GBP/USD will start heading in a certain direction, the trading range for a profitable outlook will be much larger as opposed to doing nothing and just waiting for it to expire at the right level.

It all depends on how you apply the gamma hedging strategy, I would recommend a tight gamma hedging strategy as opposed to the wide hedging strategy (as extensively discussed in “How to Calculate Options Prices and Their Greeks” chapter 14 on Strategies). After all it is a gamma short strategy.

#Call #Delta #DeltaHedging #Gamma #Hedging #Kurtosis #Options #OptionsTrading #Put #Theta #Vega #VegaConvexity

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