Forex traders quietly purchase options to hedge against "tail risk": beware of extreme fluctuations in oil prices to $70 or $150.

Forex traders are increasing their use of hedging tools to prepare for extreme volatility and the next developments in the Middle East situation. Following the initial impact of the outbreak of war in Iran and the surge in oil prices to $100 per barrel, investors are taking advantage of a relatively calm period to buy low-probability options that will bring profits when currency exchange rates suddenly fluctuate. On the surface, market sentiment appears calm: the one-month volatility for the euro is 7.68%, significantly lower than the year's high, only slightly higher than the one-year average of 7.09%. The euro has fallen to its lowest level since August last year, while the US dollar index has climbed to its highest point since early December last year. However, on closer analysis, traders are preparing for a new round of intense volatility, which may be triggered by two situations: escalating tensions leading to a surge in crude oil prices to $150; or tensions easing, clearing obstacles for oil prices to fall to $70. This is most evident in so-called butterfly options, which allow traders to hedge extreme exchange rate volatility risks. In early March, demand for euro against the dollar options reached the highest point in 11 months, and it remains strong, almost double the average level of the past year. Similarly, the demand for dollar against the yen options is following the same trend. Market expectations for how the Federal Reserve will respond to the crisis help explain why, despite an increase in demand for hedging against severe volatility, market volatility remains within manageable levels. Analysts at Danske Bank believe that the surge in energy prices is unlikely to fundamentally change the Fed's policy path this year. The analysts point out that comparing the current situation with the Russia-Ukraine war in 2022 is inappropriate and the degree of spillover inflation effects this time should be smaller. The skewness of the US dollar volatility (an indicator reflecting the difference in demand between call options and put options) continues to climb, reaching a new high for the year. This indicates that investors purchasing tail risk protection are still paying for volatility, but directional position investors are increasingly bullish on the US dollar.