Forex Options Signal Euro Breakout Potential in Week Ahead

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.

Our range-breakout barometer continues to predict that the euro will see large price swings in the week ahead. Given two-week implied volatilities significantly above their three-month counterparts, options traders are clearly gearing up for further sharp price moves through shorter-term trade. That said, we likewise see that three-month vols have fallen a bit from their recent heights, and such moderation suggests that we will subsequently see volatility slow from recent levels. Current conditions nonetheless suggest that breakout strategies will prove the most effective in the coming two weeks of EURUSD trade.

1.4821 Breakout

Our range-breakout barometer accurately predicted the continued surge in British Pound volatility, but a more recent moderation in implied vols suggest that GBPUSD price action may slow in the week ahead. Last week we wrote that a two week-three month implied spread of 0.72 clearly signaled that traders were gearing up for sharp price moves. The spread has more recently dropped to 0.28 and longer-term implied volatilities have fallen from their heights—both clear signals that realized volatility will likely slow through the upcoming days. Of course, with a BoE rate decision due Thursday, we would suggest to look for moderate volatility in the week ahead.

1.9672 Moderate Volatility

Our volatility outlook for the USDJPY is similar to that of the GBPUSD, with a drop in our implied volatility spread and longer-term vols both signaling a slowdown in USDJPY price action through the coming days. Indeed, we see that implied volatility on 3-month options has fallen by over two percentage points within a relatively short period of time. Yet we hesitate to call for rangebound conditions on the extremely risk-sensitive currency pair. Our range-breakout bias subsequently calls for moderate USDJPY volatility in the week ahead.
106.36 Moderate Volatility

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