The British pound looks set to break out soon. The only question is whether it soars or crashes.
Either way, savvy investors could profit by purchasing options on exchange-traded funds.
For the last six months, the value of the pound has fetched between $1.26 and $1.32, according to data from Bloomberg. It was recently trading just under $1.32.
The reason for the range-bound trading is that investors aren't sure whether the United Kingdom will cut a trade deal with the European Union when it leaves the bloc on March 29, the scheduled date. In other words, the lack of certainty over how Brexit works out for the U.K. is keeping the currency in limbo, even though the country is enjoying a strong economy with multi-decade lows in unemployment.
But as soon as there is some Brexit-clarity then the value of the currency will likely move. Either it could plunge, or it could rally depending on whether a trade deal between the U.K. and EU gets cut. The likelihood that it stays put now seems small.
Better still, the moves could be big.
"A hard Brexit could mean 10% down for sterling," said Ugo Lancioni, head of currency management at Neuberger Berman in London. A hard Brexit refers to the U.K. leaving the EU with no deal for continued favorable trade with the bloc.
That's just one outcome. Another is a soft Brexit, which means Britain would keep its close trading links with the EU.
A legally binding deal for continued trade with the EU could lead to a jump of a similar amount, Lancioni said.
Just before the June 2016 Brexit referendum, the pound fetched around $1.44. And if a deal gets cut, its value would likely jump back up in that direction in a flash. A 10% move up from recent levels would put the value at around $1.44.
"We have evidence that once a decision is taken, then the market can move very quickly," said Lancioni.
Or put another way, you won't have time to profit from a move once the market gets confirmation of a deal or a no-deal outcome.
Clarity Coming Soon
The good news is that over the next few weeks we are likely to get the clarity required to move the pound one way or another.
While there are many moving parts to Brexit, there are two key events to watch, both scheduled over the next few weeks.
Britain's parliament on Wednesday is set to decide on extending the March 29 Brexit deadline until mid-May. Such a move would merely prolong the Brexit-related agony for the British people. Britain's prime minister doesn't want this extension to happen.
Theresa May is trying to squash the move and instead wants to push for a March 12 vote on her deal with the EU. Seasoned observers think she'll get her way.
"We now think the odds of a deal have risen from 55% to 65%," stated a recent research note from geopolitical consulting firm Eurasia Group.
But the report says the matter could be a nail-biter. "The March vote on the deal could still be very close," the report said.
In other words, while the likelihood is that there will be a trade deal, anything could happen over the next few weeks because British politics are particularly unruly at the moment.
How to Play the Likely Move
The problem with this trade is that a bet in one direction will mean you will lose a lot of money if reality goes the other way.
And that means that this is one of those relatively rare occasions when trading options makes a lot of sense. In this case, buy options on the Invesco CurrencyShares British Pound Sterling Trust (FXB) - Get Report , exchange-traded fund, which tracks the value of the British pound vs. the dollar.
There are two parts to the trade. You should buy call options (those that pay out if the value of the pound goes up), and you should buy put options (those that pay out if the value of the pound goes down).
The trick is to purchase these options with strike prices significantly above or below the current value of the pound. This is what traders call buying out-of-the-money options, meaning that when you purchase them you are betting solely on a future price movement.
Getting specific, buy March-dated calls on the CurrencyShares ETF with a strike price at $1.34 and buy puts with a strike price at $1.20.
If for some reason the pound doesn't move before the options contracts expire then you will lose what you paid for the options.
However, if the value of Sterling moves either down or up in a significant way, then the gains on one of the options (the put or the call) will far outweigh the losses on the other one (the call or the put).
Constable owns none of the securities mentioned in this story.