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.
Oct. 28, 2010: Volatility rose 15% in a matter of weeks, accompanied by an 8% decline in EUR/USD over the same period.
May 10, 2010: Volatility rose 27% in two weeks, accompanied by a 10% decline in EUR/USD extending for four weeks.
Sept. 10, 2008: Volatility soared 146% in eight weeks, accompanied by a 13% decline in EUR/USD over the same period. In each of the four cases, the 55-day moving average rose above the 100-day, leading to sharp rallies in euro volatility and substantial declines in the pair.
One exception was in August 2007, when volatility almost doubled in a matter of seven months, but was accompanied by a 10% rise in EUR/USD. One explanation to such divergence was the contrasting interest rate policies between the European Central Bank and the Federal Reserve, whereby the latter was forced to slash its discount rate while the former was in the midst of raising rates. In fact, the Fed was the only G7 central bank in easing mode at the time, which explained the entrenched downtrend of the U.S. dollar that year.
As of June 8, 2012, EUR/USD one-month volatility has had five consecutive weekly gains — the longest weekly increase since September-October 2008 when the euro started a 22% plunge that lasted three months. Meanwhile, the 55-day moving average of the EUR/USD volatility is 20 points below its 100-day counterpart. Once the cross-over does occur, both averages must continue pointing upward. This would suggest a further run-up in volatility lies ahead, with the 15.0-18.0 in EUR/USD one-month volatility a realistic target.
Traders also will discover that a protracted uptrend in euro volatility is highly likely to be accompanied by a strengthening in the VIX. Using volatility indicators in two of the most heavily traded instruments provides a lucid view of the fear factor in global markets. If the VIX fails to rise (and stay) above the 27.0-28.0 level, then care must be exercised regarding short-lived run-ups in euro volatility.
Using technical analysis such as moving average cross-over and chartist techniques to identify breakouts in euro volatility can serve as an advance signal to the EUR/USD rate, rather than the spot rate itself.
Ashraf Laidi is chief global strategist at FX Solutions/City Index, founder of AshrafLaidi.com and author of “Currency Trading & Intermarket Analysis.”