Implied volatility is one of the most tried and true methods for objectively measuring expected volatility in the spot market. Derived from currency options with different maturities, implied volatilities are used to help predict potential movements in the spot market and is one of the most popular strategies of systems traders and other professional hedge funds.
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At its most fundamental, the basic and intuitive interpretation of this implied data is often the most telling for traders. Taken alone, a steady rise in the longer-term implied volatility (the red line) is indicative of a strengthening trend; while inversely, a decline often reveals that a period of range or consolidation in spot is ahead or already in place. Additionally, the histogram or spread between the shorter and longer-term implied volatilities (the blue colored bars) tells a different perspective. As the histogram rises, volatility is expected to pick up faster in the near future relative to the longer-term range. Ultimately, this increases the probability of a breakout scenario in the underlying currency.
Euro implieds have ticked slightly lower, leading us to believe that range bound conditions are likely to ensue, at least for the time being. Subsequently, the short-long spread has narrowed considerably to below the zero line, trading 3 basis points wide. The figure is not even comparable to the positive 55 basis points from the prior week as short term implieds have come back quite a bit. As a result, with the longer term dipping to 6.65 percent, the notion is confirmed. Incidentally, the reading coincide with the last week in August, typically time for softer activity.
Sterling vols have also pared back, reiterating the range bound scenario following a short term spike in implied activity. Compared to last week?s 70 basis point reading, short term implied volatility have pulled back to 3 bps short of the zero line, with longer term implieds showing 7.35 percent compared to last week?s figure. As a result, we back the notion of a range bound picture, based widely on consolidation that should last over the next week as volume will likely be light. Economic data also runs thin, keeping our event risk small.
Although pulling back, Japanese yen implieds remain relatively high, still showing an above 12 percent reading, currently trading at 12.35 percent. Subsequently, the short term has spiked up a bit on lingering tension as traders continue to size up the full move of the correction. Estimates are for further directional bias to be established, but not before the Bank of Japan decision this week. Incidentally, the activity has also kept the spread high, as the short long differential is now showing 2 full points apart compared to last week?s 1 percentage point. Considering the recent pullback and end of the summer lull, range bound scenarios are abound.
The USDCAD currency pair has remained in consolidation, although spiking up a bit during the course of the week. Implieds continue to run higher, however, given the plateau that has seemingly formed, we are inclined to continue our assessment of a range condition for the currency pair. Incidentally, even as the longer term measure has climbed higher to 10.45 percent, the spread has narrowed considerably as short term activity has markedly declined. Compared to last week?s 125 basis point spread, the differential now shows a 45 basis point spread. Technically speaking, the currency pair looks to be confined by the 1.0600 and 1.0400 barriers.
Following the credit crunch surge, the weekly assessment has pulled back slightly in the longer term component as the implied measure trades at 13.10 percent. However, interestingly, the short-long differential has continued to move higher, trading at 265 basis points wide compared to the 190 basis point spread last week. The conditional difference may be attributed to further speculation jitters over carry trade liquidation, helping to boost the short term end of the equation. Either way, we remain steadfast in our range assessment as the currency is open to consolidation ahead of the weekend.
Written by Richard Lee, Currency Strategist for DailyFX.com