The People’s Bank of China (PBOC) determines the daily midpoint for the yuan, or renminbi (RMB), using a managed floating exchange rate system. This system allows the yuan’s value to change within a specific range, or “band,” of +/- 2% around a central reference rate. Every morning, the PBOC sets a midpoint for the yuan against a basket of currencies, primarily focusing on the US dollar. While establishing this midpoint, the central bank considers market supply and demand, key economic indicators, and fluctuations in the international currency market.

How the Trading Band Works

The PBOC allows the yuan to fluctuate within a set trading band, which means it can rise or fall by a maximum of 2% from the midpoint each trading day. The central bank can adjust this range depending on current economic conditions and policy goals. If the yuan’s value gets close to the limits of this trading band or experiences too much volatility, the PBOC might step in. By buying or selling the yuan, the central bank works to stabilize its value, ensuring changes are controlled and gradual. From the central bank’s approach, we should see the daily reference rate as a key indicator for short-term trends. The pattern of setting the midpoint stronger than market expectations shows a clear intent to prevent rapid depreciation of the yuan. This guidance makes it less likely to see significant bets on a much weaker currency soon.

Implied Volatility and Trading Strategies

Given the managed nature of the currency and its defined trading band, implied volatility is likely to stay low. Currently, the one-month implied volatility for USD/CNH options is around 4.2%. This presents opportunities for strategies that can benefit from low and decreasing volatility, such as selling option premiums with structures like short straddles or strangles. However, we need to balance this with economic data, which indicates underlying weakness and could pressure the currency down. For example, China’s exports dropped 7.5% year-over-year in May, and youth unemployment recently surpassed 20%, the highest ever. These numbers show that the central bank is working hard to counteract market forces, creating challenges for traders. With the defined +/- 2% band, we believe range-bound strategies are particularly effective. We can set up trades like iron condors with strike prices near the edges of this band, taking advantage of the high likelihood that the central bank will intervene to maintain the currency within this stable daily range. This allows us to earn premium while authorities uphold stability. We should also keep in mind historical events, like the unexpected devaluation in August 2015, which caused a dramatic increase in volatility. While we expect stability to continue, this past event serves as a warning of potential risks. Therefore, we should apply strict risk management to any positions we take to prepare for possible sudden changes in policy. Create your live VT Markets account and start trading now.

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