USD/JPY implied volatility is being crushed as a lack of realised volatility drives the benchmark 1-month expiry vol down to 6.9, half a vol lower than just yesterday, and without BOJ intervention it could soon be trading below the recent 4-year lows at 6.6 posted ahead of the BOJ's April 30 intervention, when USD/JPY was sold from 160.00 to the 155s. On the surface, this looks like a market that has completely given up on volatility.

But butterfly spreads tell a different story. Butterfly spreads show the implied volatility differential between at-the-money straddles (the body) versus low delta calls and puts (the wings), which in USD/JPY hold a premium for the wings. In times of low realised volatility or when there is a lack of directional risk premium, the wings typically reduce their premium over the body and favour sellers. During a bout of extreme volatility, however, low delta strikes typically post bigger implied volatility gains than those near the spot rate and can be profitable to holders.

It is therefore interesting to note an increase in the wing-to-body implied volatility premium in sub 1-month expiry low delta USD/JPY butterflies, despite the current lack of USD/JPY volatility. One-month 10-delta butterfly spreads are trading at 1.2 vols — having doubled since last week — with an even bigger differential in sub 1-month expiries. The wings are stubbornly bid even as the body collapses. This divergence is the market's canary — or rather, its butterfly — in the coal mine.

The story is asymmetric. The body is falling because USD/JPY is going nowhere and implied volatility is falling. But the 10-delta wings are a different matter, especially the JPY call wing, which is favoured to hedge against a sudden and aggressive BOJ intervention. Nobody wants to be short a JPY call when that call comes.

The result is a volatility surface that looks cheap in the main body but is quietly pricing fear in the wings. The butterfly spread is not just a volatility trade, but the market whispering that the BOJ intervention threat remains real.

Related comments -

Cheap and compelling - the case for AUD/USD options

Deutsche Bank's FX focus sidesteps US dollar for crosses
USD/JPY spot and 1-month 10 delta butterfly spread


1-week and 1-month expiry USD/JPY FXO implied volatility


(Richard Pace is a Reuters market analyst. The views expressed are his own)