By Saikat Chatterjee and Tommy Wilkes
LONDON (Reuters) - Foreign exchange derivatives indicate markets are bracing for a fresh round of volatility in sterling, with investors ramping up purchases of options giving them the right to sell sterling if Brexit uncertainty escalates.
British assets suffered a sharp selloff after British Prime Minister Theresa May's Brexit deal sparked a wave of resignations, raising serious doubts about her leadership and whether the United Kingdom can avoid a disruptive exit.
The pound fell almost 2 percent against the dollar <GBP=D3> and the euro <EURGBP=D3> on Thursday, a magnitude not seen since shortly after the Brexit referendum in June 2016.
It regained some poise on Friday but investors are taking no chances; market players report a dash for derivatives markets to ensure portfolio returns are not wiped out by wild sterling swings.
"There is a lot of uncertainty out there and investors are doing the prudent thing by adding more protection," said Jennifer Hau, an FX strategist at Credit Agricole.
In the last few weeks, despite the dramatic daily moves in sterling, traders have appeared reluctant to push the currency outside recent ranges until there is a clearer political resolution in sight. Thursday's drop only took the pound back to October levels.
Now, as worries grow that May - if she survives - will fail to get her deal through parliament, financial options suggest traders have turned deeply pessimistic on sterling's outlook.
One-month sterling risk reversals <GBP1MRR=>, an indicator of investor views on the currency's short-term direction, are now at their lowest levels since September 2016.
GRAPHIC - Sterling positions and valuations: https://tmsnrt.rs/2Pyc26k
The lower risk-reversal prices trade at the more investors are demanding put options - which give investors the right to sell the pound at a future date - over call options, which give investors the right to buy.
That signals that investors are preparing for more sterling weakness by either betting on more downside or buying protection should the currency take another leg lower.
That rush to protect portfolios is also reflected in market expectations of swings in the price of the pound between now and the end of 2018.
One-month implied volatility <GBP1MO=> gauges have spiked to their highest levels since July 2016. At over 15 percent, one-month volatility has entered territory normally reserved for emerging market currencies. Indeed, one-month volatility is now trading higher than that of the Brazilian real <BRL1MO=>
"I'm just trying to keep track of what's going on and it is like watching the car crash unfold in front of us," said David Keir, Edinburgh-based co-manager of the TB Saracen Global Income and Growth Fund.
"It clearly feels like maximum uncertainty at the moment."
BRACING FOR VOLATILITY
All options are on the table as May fights for survival, including the possibility of a UK general election or a second Brexit referendum.
Investors appear most concerned about the next few weeks - one-month options that help protect portfolios between now and mid-December are trading at their biggest premium over 12-month options in more than two years.
GRAPHIC: GBP 1 month rolling volatilty returns - https://tmsnrt.rs/2PwApBf
The market remains heavily short on the pound, and investors are well aware that any glimmer of a breakthrough could trigger a massive relief rally.
Hedge funds deeply pessimistic on the currency have been caught out when Brexit negotiations take a sudden turn for the better.
Didier Saint-Georges, who helps manage more than 50 billion euros (£44.4 billion) at Carmignac Gestion, says investors should avoid direct exposure to the currency if they can.
"It could really go a big way in both directions," he told the Reuters 2019 Investment Outlook Summit.
(Additional reporting by Helen Reid; Editing by Sujata Rao and Patrick Johnston)