After big rise, pound to pause around $1.35, options markets suggest

Having enjoyed a 2% surge on Friday following Boris Johnson's thumping election win, sterling may have to pause for breath, with derivatives markets implying the currency will struggle to rise beyond $1.35 in the next few months.

The British prime minister's victory gives him a clear mandate to take Britain out of the European Union by the Jan. 31 deadline, raising hopes the country can draw a line under three years of political chaos that has stymied investment and hobbled economic growth.

Sterling bulls also argue that the sheer scale of Johnson's win will sideline the eurosceptic fringes of his party, allowing for a more favourable trade deal with the EU, possibly even within the tight 11-month deadline.

The election has fuelled a collapse in overnight implied volatility -- a gauge of expected swings embedded in currency option markets - to 8%. from 3-1/2 year highs of around 45% before the election. One-month vol has meanwhile more than halved to 9%.

But derivatives markets also suggest that sterling will take a breather before it can build on its 13% rally since early September.

Data from the Depositary Trust and Clearing Corporation (DTCC) shows investors hold around 8 billion pounds of options expiring over December-January, with strikes - the price at which an option can be exercised - clustered around $1.35.

There are sizeable option barriers around $1.35 too, traders say, referring to levels which can yield holders a payout should they remain untouched through expiry.

All that suggests the pound could be capped around $1.35 in the near-term - exactly the level where it has stalled.

Implied vol also remains well above that of other currencies. "Downside risks outweigh the topside risks for sterling, at least for now," said Stephen Gallo, head of FX strategy at BMO Capital Markets.

"I would not sell spot (sterling) but would be looking at three-month puts ... that's related to the economic uncertainty, trade uncertainty, downside risks to the global economy.

"All that suggests there needs to be a negativity in the risk-reversals skew in the next few months."

Gallo was referring to the large implied volatility premium for sterling "puts" over "calls" which points to greater demand for options giving holders the right to sell rather than buy.

Options markets have a bias for sterling puts over three-, six- and 12 months, Gallo noted, adding this was the case even after the positive election shock sent the three-month "skew" spiking to minus 0.8% from minus 1.8%.

Many banks advised not chasing sterling any further for the time being, until economic data confirms over coming months that the British economy is indeed over the worst; data of late has consistently surprised to the downside, a Citi index shows.

Finally, positioning may not be on the pound's side either.

Net 'shorts' on sterling have been pared from record highs, according to the US Commodities Futures Trading Commission (CFCC). But various banks' platforms tell a story of even more bullish positioning. On BNP Paribas' client platform, for instance, "long" sterling positions have risen to the biggest in five years, the bank's currency strategist Parisha Saimbi said.

"Profit-taking on extended long sterling positions may also cap sterling upside in the near-term," she added.