FX traders can improve certainty with respect to euro trends by focusing on the EUR/USD’s one-month option volatility, which tends to move inversely to the spot price. Applying technical analysis to EUR/USD’s volatility can help improve confidence in identifying inflection points in the spot value.
EUR/USD’s one-month volatility uses implied volatility as a measure of market-expected volatility of the euro against the dollar until the maturity of the one-month option. Future volatility is the most important variable in the most common option pricing model. Often moving in tandem with the CBOE Volatility Index (VIX) — used for gauging options in the S&P 500 — the EUR/USD one-month volatility has had a powerful record in tracking shifting euro fortunes.
One recent example was in the week ending May 18, 2012. EUR/USD volatility extended its rebound (negative for EUR/USD spot) above the trendline resistance from the September 2011 high. Any breakout of an eight-month trendline is deemed significant. In the case of the euro’s volatility, this proved a vital leading indicator at a time when EUR/USD spot had not yet broken below the key support of $1.2626. The breakout in volatility provided us with a one-week lead.
Such escalation in euro volatility above key resistance levels reflects the sharp ascent of the fear factor in holding euros beyond habitual parameters. The inverse correlation between EUR/USD spot rate and one-month option volatility shows the interrelation between currency rate and volatility.
Using the 55- and 100-day moving averages as a tool for gauging trend also has proven helpful in determining the extent of euro volatility. Such patterns are known as “golden crosses,” whereby a shorter period moving average crosses above a longer term moving average. “Death by volatility” illustrates the last four cases of death cross patterns using 55- and 100-day SMA in euro volatility.