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.
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.
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Short term implied have grown incredibly expensive as compared to their longer-term counterparts, with the challenge on the psychologically significant 1.4000 mark clearly to blame for the jump in short-dated options demand. Yet such a surge in the weekly short-long spread typically coincides with stabilization in market conditions, as options traders balance out the volatility curve. Given previous experience, we would expect the EURUSD to settle to smaller price movements in the coming week of trade.
The volatility curve on the Pound Sterling is unsurprisingly similar to that of the euro, with a surge in shorter-dated vols pushing the spread to a noteworthy 1.38 on the week. Given such an incredibly strong jump, however, we feel that it is likely that shorter-dated options will settle towards their recent ranges. This likewise suggests that volatility may die down in the GBPUSD, with markets to digest recent price action before showing strong directionality.
Recent price action has left overall implieds on the USDJPY significantly lower, with a shrinking spread between short and long-dated options raising the possibility of a return to strong volatility through the coming week of trade. Though we may have to wait until the curve flattens further, current signs point to a breakout on the USDJPY and traders should be mindful of strong price moves in the Japanese currency.
The USDCAD has shown perhaps the most interesting price action out of the majors, with strong demand for longer-dated options pushing the short-long spread strongly negative for the first time in months. This would typically signal a potential short-term breakout in the currency, but overall gains in the vol curve cloud the outlook for the USDCAD. As such, we maintain that the Loonie will see moderate volatility in the week ahead.
Long-dated Australian dollar implied volatilities have surprisingly fallen despite the currencys recent breakout. This has left the short-long spread higher on the week, and signals the fact that volatility may slow through upcoming trade. Yet the elevated levels on the short end of the curve leave caution to call for range trade; instead, we feel that the currency pair will see moderate volatility through the coming week of trade.
Written by David Rodriguez, Currency Analyst for DailyFX.com