Forex Options Markets As Forecasting Tool Point to EUR/USD Top

Forex options markets offer an excellent sentiment indicator and can be quite useful as a sentiment indicator for currency traders. As is well known, there is no central market for leveraged forex trading. Instead, the market is spread across a great number of banks and other financial institutions. Yet there are all the same data sources that aggregate important forex positioning data, and recent signals increasingly point to a major EUR/USD top.

[B]Forex Sentiment Indicators[/B]

We would love to claim that our proprietary Speculative Sentiment Index is the be-all and end-all of forex sentiment indicators, but the fact of the matter is that it does not capture the entire FX Market—no indicator does. To gain a more complete understanding of positioning for the most important forex pairs, we look to publicly available Commitment of Traders data published by the US CFTC and more timely information from major banks.


Put simply, we want to capture as good a snapshot of market sentiment as possible. Through the COT report, we are able to view a wealth of information on well-segmented groups. The CFTC separates their samples into three different categories—Non commercial traders, Commercial traders, and “Nonreportable”. The first group is the one that most interests us—classic forex market speculators. Here we find traders who latch on to trends and tend to outperform the broader market during times of strong, directional currency moves.

The second group comprises mostly multi-national corporations with hedging interests in the FX market. That is to say, if Toyota wishes to lock in future obligations at a specific US Dollar/Japanese Yen exchange rate, it may go through futures markets and purchase FX contracts.

The combination of both pools gives us an interesting view of the FX market. In fact, our weekly COT report (most recent example here) ranks the relative positioning of both Commercial and Non-commercial traders to develop an accurate picture of market sentiment—often quite useful to predict future currency price direction.

Yet there is a key limitation to COT data: it is a weekly report published with a noteworthy delay. The low-frequency nature of this data makes it very difficult to use for more short-term trading strategies. Thus it is very challenging to use as a market timing tool, and we instead look to broad positioning to attempt to identify sentiment extremes.

Where do we look for more up-to-date professional trader information?

[B]Forex Options Markets[/B]

Though the CFTC provides detailed and informative positioning reports, we are forced to look to Over-The-Counter (OTC) FX Options markets for a more up-to-date look at professional trader sentiment. The world’s foremost banks and other financial institutions are the primary actors in this market, and each individual trading desk provides up-to-the-minute data on important options pricing information.

If we know options prices and other key details, we are able to glean an all-important piece of information: volatility expectations.

[B]What is Implied Volatility and Why Should the FX Trader Care?[/B]

“Implied Volatility” is a measure derived from all options prices, and it gives us one of the best estimates for professional trader market expectations. On DailyFX we publish our “DailyFX Volatility Indices”, which use FX Options markets to gauge trader expectations for currency price moves. Given that said implied volatility level is so critical to the prices paid for options, they likewise give us an accurate view of market expectations for specific currencies.

Risk reversals measure the difference between volatility levels for out of the money Puts and Calls. If demand for out-of-the-money call options is stronger than demand for the equivalent puts, options traders are on aggregate bullish a given currency pair and are willing to pay more for calls. This makes Risk Reversals positive.

[B]Why is this a good proxy for professional trader positioning?

The chart shows that medium-term risk reversals tend to track net Non-Commercial positioning quite nicely—exactly the kind of proxy we’re looking for. In fact, we tend to see EUR/USD risk reversals hit major peaks and troughs before the delayed COT data can illustrate sentiment extremes. Though not perfect, we see that FX options markets can offer an excellent view on professional positioning figures.

[B]What do FX Options Markets tell us about the Euro/US Dollar?[/B]

What we see right now is the confluence of Commitment of Traders data and FX Options Risk Reversals: US Dollar positioning is setting major bearish extremes.

According to our FX Commitment of Traders report, the difference between Non-Commercial and Commercial positioning on the US Dollar Index is currently at its most bearish in over 13 weeks, while Euro/US Dollar positioning set similar bullish extremes. Our options numbers show that risk reversals on the Euro are actually at their most extreme since 2003—impressive numbers by any measure.

Much like we do with our COT report, it is useful to put a percentile on these risk reversals figures to get a sense of where sentiment stands in relation to its medium-term range.

The chart above shows an interesting and important relationship between risk reversals and the underlying EUR/USD price: yearly extremes very often coincide with major spot reversals. In fact, there were six relatively clear instances in which the sentiment extreme in 3-month risk reversals occurred at an important top in the EUR/USD.

As the chart shows, our EUR/USD risk reversal percentile recently hit its highest levels in the calendar year, and said price action suggests that highs of 1.4350 will be an important medium-term top. If we see anything like we did at the March sentiment extremes, the EUR/USD could correct for the next month or so before any potential push higher.
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