Currency volatility trading

The options market is a forecasting model, continuously adjusting prices based on expectations of future movements of underlying assets. The market is sensitive to time because options have expiration dates. Erosion of time means value is disappearing. One focus of the options market is valuation over a relatively short period compared to assets that have no expiration date.

Another focus for valuation of options is volatility of the underlying. With time growing short, it is imperative for the underlying price to move toward a profitable level — either up or down depending on the trading strategy. Options that reflect low volatility for the underlying quickly move down in value, approaching a price of zero or intrinsic value (the underlying price less the strike price) before those that have superior implied (or predicted) volatility.

Volatility differences are illustrated in “Forex calls: January 2014” (below). The Japanese yen (CME:J6M14) is the current champion of volatility, primarily due to the strategy of Japan’s central bank to keep interest rates low enough to drive the yen’s value down. The yen’s volatility is expected by the options market to remain high at least through the next six months because these are calls that will expire in June 2014. What if — similar to the U.S. Federal Reserve Bank’s decision to taper its Treasury purchases — Japan’s central bank decides to keep its currency at a level price with reduced volatility? This possibility and others like it at central banks in other countries make it important for traders in forex to consistently assess central bank intentions and the economic background for their actions.

A good pair

The situation with yen futures and options, while interesting from a trading perspective, does not involve a pair. A good trading pair should have the following qualities: 1) the two currencies have closely coordinated volatilities; 2) their price movements are closely matched; and 3) the central banks have stable monetary policies that permit low-risk spread trading when the currencies vary from their usual relationship.

During the past two years, the Swiss franc (CME:S6M14) and euro (CME:E6M14) have been an outstanding example of a forex trading pair. The three points above are supported by the announcement by the Swiss central bank in September 2011 that the franc should not be valued at less than 1.20 euro. “Swiss franc and euro ETFs” (below) shows how well the Swissie has adhered to this objective, as illustrated by the matched price movements of the euro and Swiss franc exchange-traded funds. For more than two years this pair has offered trading opportunities. 

We may look back to November 2011 to see the forecast given by, “Forex calls: November 2011” (below) for options on March 2012 futures. The highest call price curve and the one indicating the most volatile underlying is the Swiss franc. The franc is followed by the Australian dollar, euro, Canadian dollar and British pound (CME:B6M14). 

Just as the Swiss franc is more volatile than the euro, the Australian dollar (CME:A6M14) and Canadian dollar (CME:CDM14) are more volatile than their pair trading partner, the British pound. If it is fair to call major currencies subservient, those related to the euro and the pound are subservient to their respective senior partners.

The senior-junior relationship is reflected in a non-forex pair, gold (COMEX:GCJ14) and silver (COMEX:SIJ14), in which silver futures and options are more volatile than gold’s because silver’s price movements are keyed to changes in the price of gold. In the case of gold and silver, the world’s markets instead of a national central bank create the trading pair. 

“Canadian dollar, British pound ETFs” (below) shows the characteristic paired pricing described for the Swiss franc and euro. The Canadian monetary authorities kept a firm hold on the pound through August 2013. At that time, the currencies separated, with the British pound escalating toward a closer relationship with the euro and the Canadian central bank allowing its currency to slide to a lower level. The combined decisions produced a sharp upturn in the dollar difference between the ETFs. The pair had oscillated within a range of $10, but the difference suddenly increased by another $10. 

On “Forex calls: January 2014,” the yen is the most volatile for good reason, seeing its 30% decline in value during the past two years. However, it is also noted on “Forex ETFs” (below) that the decline slowed after May and June 2013. The higher volatility rating for the yen may not be justified if the previous decline in price has fulfilled the economic objectives that Japan’s central bank had in mind. If this is true, calls and puts on yen futures may be overpriced  in  the first quarter of 2014

Intentions of central banks that control subservient currencies may be analyzed in part by observing the ratio between their currencies and the senior currency to which they are tied at least temporarily. The reasons for the attachment vary: lowering interest rates for domestic economic purposes (Federal Reserve Bank, European Central Bank, Bank of England), reducing the price of their currencies for the purpose of international competition (Japan and more recently Canada and Australia), or defending its currency from inflows due to desire for a safe haven from euro-based economies (Swiss National Bank).

Related markets

Ratio analysis of three currency pairs is shown on “Forex ratios” (below). They are euro-to-Swiss franc, euro-to-Australian dollar, and British pound-to-Canadian dollar. The virtually horizontal line at just above a ratio of 1.20 represents the commitment of the Swiss National Bank to defend its currency. The Australia and Canada central banks held on until April and May of 2013. At that point, Australia and Canada opted to weaken their currencies internationally and Great Britain hinted at a tighter monetary policy

The concise nature of the forex ratios extending two years for the franc and almost a year and a half for the Australian and Canadian dollars is evidence that they really had little independent volatility during those time periods other than short-term variations around the more stable member of the pair. “Forex calls: November 2011” suggests that the volatility relationships were recognized by the options market. The Canadian dollar call option price curve is slightly higher (more volatile) than the British pound, and the Swiss franc and Australian dollar price curves are higher than the euro. Thus, the structure of forex call prices in November 2011 made a reasonably good forecast for the following two years.  

A similar forecast is shown on “Forex calls: January 2014.” The volatility structure reflects the currency relationships extending from 2012 and 2013. At the bottom of the chart with the lowest projected volatility is the British pound with a curve height of 1.71% (call price-to-strike price). The pound’s trading partner, the Canadian dollar, is slightly more volatile at 1.81%.

Currencies connected to the euro are also placed to continue their relative price movements. The euro call curve height, 1.74%, is topped by the Swiss franc at 2.25% and Australian dollar at 2.37%. The yen, at 2.56% exceeds the other currencies’ implied volatilities, and as mentioned earlier, the forecast of high volatility for the yen may result in overvaluation of related futures and options.

In a world of shifting economies, interest rates, and currency values, forex traders should look to central bank strategies in determining the direction and timing of trades. The volatility structure assists in the forecast of currency futures price trends.

Also, read, Top 10 reasons to trade FX.

Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.

About the Author

Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.