FX Option Volatilities What are they?

FX option volatilities measure the rate and magnitude of the changes in a currency's price. Implied option volatilities measure the expected fluctuation of a currency's price over a given period of time based upon historical fluctuations. Volatility is measured by calculating the past annual standard deviations of daily price changes. Volatility is one of the key components of option pricing. Higher volatilities generally make option premiums more expensive. Professional option traders will typically buy options when volatilities are low and sell options when volatilities are high. Traders who only trade volatility need to hedge their options by buying or selling spot foreign exchange.

How is it used in Foreign Exchange?

When option volatilities are low - Look for a potential breakout When option volatilities are high - Look for range trading opportunities

Option volatilities are useful in timing FX movements. When currencies range trade it is likely that implied option volatilities are declining. The reason this happens is because range trading means lack of movement, by definition. When option volatilities have a pronounced movement downwards, this is usually a good signal for a significant upcoming movement and this is very important for both range and breakout traders. Traders who usually sell at the top of the range and buy at the bottom, can use this tool to predict when their strategy will stop working. Breakout traders can monitor option volatilities to make sure that they are not buying or selling into a false breakout.

The EUR/USD and GBP/USD charts on the following page contain examples of when sharp drops in option volatilities have predicted large moves in the FX market. These specific examples highlight upward movements, but are equally as useful for the inverse. In April of 2003, EUR/USD 3 month implied volatility took a sharp plunge downward when EUR/USD was trading within a tight range. If a trader bought EUR/USD based upon this move in option volatilities, he would have been in the market for the 700 pip move that occurred during the following 3 months.

There is also a case for GBP/USD. In April of 2003, option volatilities plummeted from 8% to 7.3%, while GBP was range trading. In the following months, GBP/USD rallied from 1.5550 to 1.6100. This strategy generally works well, but traders must be cautious because volatilities can have long downward trends. This is evidenced in the period between June 2002 and October 2002. Therefore, it is important that traders look for sharp movements in volatility as opposed to gradual ones, because declining volatilities can be misleading.