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.
EURUSD
Both long-term and short-term implied vols soared last week as a currency market thin in liquidity helped leverage vulnerable volatility. The break in both derived implieds and underlying spot was substantial. Expectations for more active price fluctuations over the shorter term jumped over 1.5 percent, while those with a more distant outlook made similar advances. The substantial shift in volatility levels (the biggest increase in our look-back period) accompanied a huge break in EURUSD spot through 1.2900 resistance that finally wound down around the 1.3200 level. Interpreting the vols environment now, both terms of implied volatility are still perched near their highest levels in two months, suggesting the market is lifting volatility premium in the belief that a follow through or sharp retracement is near.
GBPUSD
Compared to the euro, the British pound made an even more decisive technical break in spot action this past week with a 500-plus point rally that found some level of market equilibrium around the 1.95 figure. The long-term implied indicator shot nearly 2.5 percent higher as market participants saw the confines of range boundaries giving way to open skies. However, the spread shows there is a level of caution in the mix. Though the extended vols gauge holds resiliently to its high, short-term implieds have begun to cascade lower. This sets up a split scenario. Should both the spread and long-term indicator plunge further, range action can set in. Otherwise, if the spread goes it alone on any further drop, the expectations surrounding a long-term pick up in price may encourage a new trend.
USDJPY
While market participants were driving expectations for future volatility to new highs in many of the majors, the same enthusiasm was not underlying USDJPY. Though the long-term gauge picked up nearly one percentage point from its record lows over the past week, the consequential level was nothing overly impressive. The same was true of the vols spread, which sporadically oscillated around the par level. This relatively tepid response to the anti-dollar rally was born out of the quick reversion to modest ranges after the 120-point candle last Wednesday. With the implieds differential still holding out near par though, a level of confidence behind another big move comparable to last weeks exists. Whether or not this comes about though will depend on momentum around 115.50 and 116.50.
USDCAD
Implied vols for the USDCAD have steadily risen since underlying price action was firmly rejected by 1.15 resistance. Since the ill-fated attempt to surpass the level, spot was steadily pushed down to 1.1300 with expectations of future activity rising consistently in tandem. From a new record low set last week, long-term implieds have risen nearly 0.5 percentage points. Juxtaposing this steady rise in the derivative to the drop in the underlying suggests the market believes the spot decline will unfold into a bigger trend. However, this does not necessarily mean the recent leg down will be the de facto direction. Despite making a sharp jump off of 1.13 support, USDCAD implieds were little effected by the change of course, which may imply the pairs rising trend channel is on most traders screens .
USDCHF
Equal only to the GPBUSD, longer-termed Swiss franc implieds soared last week as the underlying currency pair cascaded lower. After a nearly 2.5 percentage point rally in the distant volatility gauge, prospects for a more active market reached levels not seen since the beginning of July. However, confidence that the impressive 400-point drop was the beginning of a broader trend lower was tempered by an advance in the short-term measurement that soundly outpaced it, evident in the rise in the spread. With the combination of technical support at 1.2000 in spot and turn lower in both the long-term and spread indicators, there appears to be building confidence that a bottom has been found, at least temporarily. On the other hand, with vols still at high levels, the market could change quickly.
AUDUSD
Though the Australian dollar was consistently pushing to new 20-month highs this past week, implied volatilities derived from the underlying spot action have hardly reflected the stellar trend. Since this recent swing higher developed three weeks ago, long term vols have been barely nudged higher. The peak of enthusiasm behind the run was reported when AUDUSD broke above 0.7775, a resistance level set in place only a few weeks ago. Confirmation that there was little momentum building into the recent Aussie rally was offered when the move above 0.7800, a considerably bigger level of resistance, found little response from the measures of volatilities. Now, struggling implieds and stalling price action reveal expectations for activity to die down and price action to stabilize.
