The proposed exit of Britain from the European Union went from disorganized to outright chaotic during the last week.
At this stage, the best thing that Britain has going for it is Scotland’s presence in the United Kingdom, which means the entire British population can lean heavily on the strong spirits originating from that region.
Based on recent developments, they’ll certainly need a quaff or two of whiskey.
Confounding British voters, Parliament in the United Kingdom recently rejected both the "soft" and "hard" Brexit deals that were up for consideration during the first half of March. In the aftermath, most expected that the European Union would grant the UK an extension to Brexit, so that an orderly disengagement could still be arranged.
Throwing a wrench into those expectations, the leaders of the EU region instead recently offered two choices to Britain in this continuing (and now tiresome) saga. For all intensive purposes, the “hard” Brexit deadline has been pushed back from March 29th to April 12th.
This in itself was a big surprise, because the British had been expecting nearly three months of extra time, not a few extra days. As if that wasn’t enough, the EU also put some conditions on the bonus time.
Basically, until April 12th, all options remain on the table. Britain could elect for a “soft” Brexit (i.e. a negotiated deal with the EU) or a “hard” Brexit (i.e. “no deal”) - or they could elect to revoke Brexit altogether.
After April 12th, things get a lot more interesting.
Based on the conditions offered by the EU, if Britain doesn’t make a choice by April 12th, then a new deadline takes effect (May 22nd) before which Britain must execute the “hard” Brexit.
Complicating matters further, one can’t overlook the fact that Britain could still decide at the last minute to leave the EU on March 29th, as previously scheduled.
While this particular outcome may seem unlikely, the majority of the British population did support the notion of Brexit in 2016, which means the political pressure to comply with the March 29th deadline could crescendo into a frenzy in the coming days.
On the other end of the spectrum, is the remote possibility that yet another referendum could be held in order to “reconfirm” that Brexit is truly supported by a majority of voters. The premise for a second referendum is supported by the fact that many of the complications associated with Brexit weren’t well understood when the first referendum was conducted.
Compounding the situation further still is the March 27 announcement that Theresa May will bow to pressure from the Conservative Party and step down to win backing for the deal.
Given the vast array of choices, and the zig-zag nature of the process to date, the only certainty regarding Brexit appears to be that nothing is certain. It’s moments like these that remind us numbers don’t lie, and that sometimes we can learn a lot more from a quantitative analysis, than a qualitative one.
Looking at a recent price chart of the British Pound, one can see that the currency strengthened considerably after the "soft" and "hard" Brexit deals were voted down. At that time, many currency analysts believed that the prospect of Britain staying in the European Union had increased (the Pound was considerably more valuable before Brexit popped up in the first place).
As of now, picking the direction and ultimate value of the Pound is obviously an extremely difficult proposition. That’s where the importance of implied volatility and mean reversion come into play.
The Pound suffered a huge decline in the wake of the initial referendum in 2016, and as a result of that market shock, implied volatility in Pound-related products has remained stubbornly high. Interesting, however, is that fact that actual volatility (in some Pound-related products) has underperformed implied volatility in the time since the referendum - a pattern that was outlined in detail on a recent episode of Closing the Gap: Futures Edition.
As a reminder, /6B is the futures ticker for the British Pound to US Dollar exchange rate. Alternatively, traders can reference the ETF with the ticker FXB, to review recent movement in the British Pound.
Looking back at the British Pound (/6B) price history, and the associated futures options, the Closing the Gap team highlights that if a single short strangle had been initiated on June 23, 2016 (the day of the British Referendum on Brexit), it would have yielded a loss of $3,175 due to the unexpected volatility which materialized in the aftermath of the vote.
However, the team also looked back and saw that British Pound volatility remained stubbornly in the aftermath, while actual volatility in the underlying has been more muted. According to tastytrade research, selling the same strangle in the British Pound every month since Brexit would have yielded a total profit of $4,294.
The second half of the episode focuses heavily on Implied Volatility Rank (IV Rank), and how the metric can serve as a much better indicator for traders when compared to qualitative news headlines - the latter of which can often be "sensationalized" to draw in readers/viewers.
In order to drive this point home, a short study was conducted by tastytrade that looked back at selling strangles in the British Pound (/6B) since the Brexit referendum. An important distinction was that the data was filtered into two groups - all occurrences, and then only instances in which IV Rank was above 50%.
As you can see in the slide below, which summarizes the results of that study, the trading approach which leveraged heightened levels of IV Rank produced far superior trading results, on average:
What we can see from the above data is that the use of IV Rank as a trading signal yielded a higher overall success rate and a higher average P/L when compared to trading “all occurrences.” With several important new dates established on the calendar relating to Brexit, one would think that IV Rank in Pound related underlyings will spend some time above 50% in the foreseeable future.
In order to learn more about these potential trading opportunities, we hope you'll take the time to review the complete episode of Closing the Gap: Futures Edition focusing on volatility in British Pound futures when your schedule allows. For more information about futures options, look no further than this previous blog post - “Introducing Options on Futures.”
If you have any questions about this material don't hesitate to leave a message in the space below, or reach out directly @tastytrade (Twitter) or firstname.lastname@example.org (email). We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.