Forex Options Show US Dollar Sentiment Extreme, Bounce Likely

Forex options markets currently show traders are the most bearish the US Dollar in the past calendar year—bolstering the case for a noteworthy US dollar bottom. In fact, Euro/US Dollar risk reversals now show that traders are the most bullish the EUR/USD since early 2003.

Volatility is a major determinant of options prices. 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.

3-month Euro/US Dollar options prices currently show the biggest premium for out of the money calls since 2003. Yet this arguably serves of little use to us since it is very difficult to compare the different circumstances. Instead we look to the relative movements in sentiment and compare risk reversals to their calendar-year range. A straightforward method to compare a number to its medium-term trend is to calculate a rolling percentile across a given time period.

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. If we look at the same chart for different currencies, we see that we are at similar extremes.

In each of the three above examples we see results similar to those seen in the EUR/USD. These four popular currency pairs all show options traders at their most bearish in the past calendar year of trading. Though it is critical to note that sentiment can remain at extremes for longer than one can expect, we would argue that this is simply the beginning of a major US Dollar bottom.
Written by David Rodríguez, Quantitative Strategist for [/B][/I]