Forex Blog: Currency Trading News & Analysis.

May 5th 2007

Commentary: Implied Volatility Explained

Technical analysts use a myriad of indicators and indices to
try to gauge where currencies are headed. Many seek insight in the prices of derivatives, where forwards, futures,
options, and swaps are used to make bets on the future movements of
commodities, securities, and even currencies. Let’s ignore swaps, which are more complicated and virtually
inaccessible to retail investors.  Currency
futures, forwards, and options are based on the same premise: one party agrees
to buy/sell a specific unit of a specific currency at a fixed price on or
before a fixed date in the future.  In
the case of forwards and futures, the contract represents an obligation.  In the case of options, it is a choice. 

As is probably self-evident, there are only a few variables
which determine the price of a currency option: the underlying exchange rate,
strike/purchase price, time to maturity, risk-free rate, and volatility of the
underlying currency. The first four variables are known: the fifth, volatility,
can be induced from the price of the option. You will often here of traders quoting “implied volatility” prices,
which, given the other four variables and the price of the option, can be
calculated easily enough. Based on the
price of the option, the volatility figures implicitly represent how investors
collectively view a currency’s prospects.

Volatility is worth paying especial attention to because it
can help you sort through the layers of analysis and guidance that pundits,
like myself, proffer with regard to forex markets. Implied volatility offers an instant snapshot
of how much investors believe a currency will fluctuate over the term of the
option.

Implied volatility is currently drawing the attention and scrutiny
of forex analysts because it is much lower than would be expected given the
Dollar’s recent collapse.  The USD has
fallen to a record low against the Euro and a 26-year low against the British
Pound, and many analysts, including myself, expect the Dollar to fall
further. However, implied volatility of
USD/Euro and USD/GPB options indicate that investors believe the worst of the
Dollar’s travails are behind us.  The
markets can be wrong, and in the case of currencies, which are among the most
difficult to forecast, they are frequently wrong.  But, prices do not lie: in this case, they are
telling us unequivocally that traders are not expecting further Dollar
volatility.

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Posted by Adam Kritzer | in Commentary | No Comments »

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