How Will Markets React to the Japanese Earthquake?
Today's Idea
Volatility has returned to the Japanese Yen, as the economic effects of the devastating earthquake are yet to be determined. This uncertainty has caused option volatilities to increase, making the purchase of calls or puts in the Japanese Yen more expensive. This increase in volatility may beckon some traders to explore trading strategies that could benefit should the rise in volatility be short-lived. One such strategy would be selling strangles in Japanese Yen futures options. For example, with the June Yen futures trading at 1.2221 as of this writing, the April Yen 1.28 calls could be sold and the April Yen 1.17 puts could be sold for about 0.0023, or $287.50 per strangle, not in including commissions. The premium received would be the maximum potential gain on the trade and would be realized at option expiration in early April should the June Yen futures be trading below 1.2800 and above 1.1700. Given the risks involved in selling naked options, traders should have an exit strategy in place should the position move against them. For example, some traders may wish to buy back the short strangle prior to expiration should the June Yen futures trade above 1.2800 or below 1.1700.
Fundamentals
The devastating earthquake that struck Japan on Friday has sent financial markets into a flurry of activity, as traders begin to access the potential fallout to the global economy. It is still too early to gauge the full extent of the damage brought to the world's third largest economy and any spillover effects for the world at large. The initial reaction by the financial markets was a sharp rise in the value of the Japanese Yen. Though this may seem counter-intuitive at first, it does make some sense, as traders believe that funds held overseas by Japanese corporations, individuals, and even the Japanese government, will flow back to Japan to help in the recovery and rebuilding efforts. This could trigger a potentially huge amount of Yen purchases, as funds from overseas are converted back into Yen. The need for liquidity could impact such markets as U.S. Treasuries, as Japan is one of the largest holders of U.S. debt and it is possible we could see some of these holdings sold in order to raise funds to bring back to the country. The Crude Oil market has initially sold-off on the news, as traders believe that Japan's demand for Oil will fall, at least initially, as its refineries are taken off-line and due to lower demand for jet fuel if its airports are shut down for any length of time. Longer-term, rebuilding efforts could trigger additional demand for such commodities as Lumber, and especially Copper, which is already in strong demand.
Technical Notes
Looking at the daily continuation chart for the Japanese Yen futures, we notice that despite the sharp rally on Friday, the front month Yen futures continue to consolidate in a narrower and narrower range. The earthquake may be the catalyst for a breakout, with the current bias favoring a test of the recent highs. We should note that prices are now once again above the 20-day moving average, and the 14-day RSI has started to turn higher, with a current reading of 56.87. The next resistance level for the June Yen is seen at the February 2nd highs of 1.2341, with support found at the February 16th lows of 1.1909.
Mike Zarembski, Senior Commodity Analyst
