Volatility comparison

Currency option volatilities measure the rate and magnitude of the past and potential future changes in a currency’s price, and they can be a useful tool for timing currency movements.

Implied option volatilities, which are reflected in option premiums, are the market’s current estimate of the future fluctuation of a currency’s price. Historical (or statistical) volatility, which reflects past price movement, is typically measured by calculating the annualized standard deviation of price changes over a given period (e.g., 20 days, 100 days).

It shows only current option implied volatilities (which are based upon a survey of interbank sources). Traders implementing this strategy would need to keep a journal tracking historical implied volatilities. Onemonth and three-month implied volatilities are two of the most commonly benchmarked time frames.

When option volatilities are low, traders should look for potential breakouts. Current implied volatility should be at least 25 percent lower than historical implied volatility. (It is best to measure against actual historical volatility, but that data is not always readily available.) Conversely, when option volatilities are high, traders should look for range trading opportunities.

Typically, when a currency trades in a range, its option volatility will decline, because by definition range trading means lack of movement. When option volatilities make a pronounced down move, it is usually a sign of a significant potential price move and upcoming trade opportunity.

This characteristic is very important for both range and breakout traders. Traders who usually sell at the tops of ranges and buy at the bottoms can use this approach to predict when their strategy could potentially stop working, because if volatility becomes very low, the likelihood of continued range trading decreases.

On the other hand, breakout traders can monitor option volatilities to make sure that they are not buying or selling into false breakouts. If volatility is at average levels, the likelihood of a false breakout increases. Alternatively, if volatility is very low, the probability of a real breakout is higher. However, traders must be careful because volatilities can have long downward trends, as they did between June and October 2002. Therefore, declining volatilities can sometimes be misleading. What traders need to look for is a sharp move in volatility, rather than a gradual one. It shows an example in the U.S. dollar/Swiss franc rate (USD/CHF). The blue line is price, the green line is the one-month (or shortterm) volatility, and the red line is three-month (or longer-term) volatility.

For most of December 2003 the one month volatility was below the three month volatility, which coincided with the development of sharp down moves in USD/CHF. Between Feb. 24, 2004 and March 9, 2004, the one-month volatility spiked above the three month volatility, which coincided with a period of range trading.