By Fergal Smith
TORONTO, June 9 (Reuters) - The foreign exchange options market is showing much less risk of a sharp drop in the Canadian dollar than before last November's U.S. election, which could spell bad news for speculators who have heavily shorted the underperforming currency.
Bearish bets on the loonie ramped up in May to a record high as Canada's largest alternative lender Home Capital Group Inc nearly collapsed in April.
But short-sellers are battling a decline in volatility that has hit stock, bond and foreign exchange markets over recent months and which implies that the Canadian dollar will not fall very far. The decline in volatility could leave sellers sitting on positions that are no longer working and looking for an exit all at once if a positive catalyst for the currency emerges.
"Canadian dollar sellers are expecting an aggressive Canadian dollar move and the market is saying it is not going to happen," said Adam Button, currency analyst at ForexLive.
Investors typically pay more in the options market for downside than upside protection in the Canadian dollar because the commodity-linked currency tends to weaken fast when appetite for risk declines.
But the drop in Canadian dollar volatility has helped reduce the premium that investors are willing to pay for puts versus calls on the currency, known as the price of a "risk reversal," to a nearly 2-year low.
"It is more of a risk-on environment than a risk-off environment and people are not afraid that there is going to be a rapid depreciation of the Canadian dollar," said Simon Côté, managing director, risk management solutions, National Bank Financial.
A Reuters poll last week showed that foreign exchange strategists expect the loonie to dip to C$1.36 to the U.S. dollar, or 73.53 U.S. cents, in the short term but to recover some ground in a year as a strengthening domestic economy encourages the Bank of Canada to prepare the market for interest rate hikes.
The currency was trading around C$1.3430 on Friday after strong domestic jobs data.
The central bank has not raised its policy rate, which sits at 0.5 percent, since 2010 but struck a more upbeat tone in May than investors had expected.
"The May meeting was a game changer in terms of viewing the currency pair from a strategic perspective," said Mazen Issa, senior FX strategist, at TD Securities.
The grind lower in risk reversals could indicate that market participants have become less bearish on the outlook for the Canadian dollar over the multi-month horizons that contracts in the option market tend to be written, Issa added.
The loonie has been the weakest performer among G10 currencies this year as oil prices fell and the Trump administration started the countdown toward renegotiation of the North American Free Trade Agreement.
Investors have also worried that record high borrowing by Canadians will weigh on the country's economy if a red-hot housing market slows.
But a positive development for the Canadian dollar, such as a rally in oil prices, could put pressure on often-leveraged speculators to cover short positions and accelerate any move higher in the currency.
"We are advising our U.S. dollar purchasers to be ready if we go back to C$1.28 ... because we might get this and it might happen fast," National Bank Financial's Côté said.
Reporting by Fergal Smith; editing by Grant McCool