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Volatility Drops, but Can US and Aussie Dollars Break Ranges?

By , Quantitative Strategist
06 May 2013 16:00 GMT

Article Summary: An important slowdown in FX market volatility warns that the Euro, US Dollar, and Japanese Yen may continue to move sideways. What could force the major break?

View this week's archived webinar for 'video version' of this article.

DailyFX PLUS System Trading Signals Forex options market volatility prices have tumbled as a lull in economic event risk, and slow price action hurts demand for bets on major US Dollar, Euro, or Japanese Yen breakouts/breakdowns.

We have little choice but to favor trading strategies that do well in such conditions—staying away from our high-volatility Breakout2 trading system in favor of our range-trading Range2 strategy and to a lesser extent the trend-following Momentum2 system.

DailyFX Forex Volatility Indices Across Major Currency Pairs

forex_strategies_that_might_do_well_in_current_market_conditions_body_Picture_1.png, Volatility Drops, but Can US and Aussie Dollars Break Ranges?

Source: OTC FX Options Prices from Bloomberg, DailyFX Calculations

Breakout2 has had an impressive run of results in the first several months of the year as Japanese Yen volatility surged, but its recent performance has disappointing as the JPY and US Dollar stick to broad trading ranges.

One of the major reasons we liked selling the Japanese Yen was a tumble in domestic bond yields, but it seems that the ‘BoJ trade’ may have stalled as global yields remain especially low. We might need to see a surge in US Government bond yields or similar out of other developed countries to re-ignite the short-JPY trade. Else the BoJ would need to force a sustained decline in JGB yields—that which seems somewhat unlikely at this point.

One trade that shows some promise is a potential Australian Dollar breakdown as the currency pair trades near critical lows ahead of the highly-anticipated Reserve Bank of Australia interest rate decision. Overnight Index Swaps are pricing in a 50% chance that the RBA will cut rates. The relative indecision suggests that a rate cut could in fact be enough to force the AUDUSD break below critical support that could set up the larger breakdown.

More broadly, the fact that we’ve yet to determine direction for the month of May makes the next several days especially significant. We wrote last week that forex seasonality studies will show that the beginning and end of a time period will often produce important highs/lows in key currency pairs. That implies that the Euro could have made either its high for the month at $1.3240 or its low at $1.2950.

Our strategy outlooks are admittedly more ambiguous than normal but that’s for a reason—it could be a great week for trend trades if we see a sustained pickup in US Dollar volatility. But current market conditions suggest we could just as easily keep to tight ranges across key USD, EUR, and JPY pairs.

View the table below to see our strategy preferences broken down by currency pair.

DailyFX Individual Currency Pair Conditions and Trading Strategy Bias

forex_strategies_that_might_do_well_in_current_market_conditions_body_x0000_i1026.png, Volatility Drops, but Can US and Aussie Dollars Break Ranges?forex_strategies_that_might_do_well_in_current_market_conditions_body_1a.png, Volatility Drops, but Can US and Aussie Dollars Break Ranges?

View how to automate the high-volatility Breakout2 Trading System via our previous article and webinar recording

Auto trade the trend reversal-trading Momentum2system via our previous article and webinar recording.

Use our counter-trend Range2 Trading system and view an archived webinar guide on automation

--- Written by David Rodriguez, Quantitative Strategist for DailyFX.com

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Definitions

Volatility Percentile – The higher the number, the more likely we are to see strong movements in price. This number tells us where current implied volatility levels stand in relation to the past 90 days of trading. We have found that implied volatilities tend to remain very high or very low for extended periods of time. As such, it is helpful to know where the current implied volatility level stands in relation to its medium-term range.

Trend – This indicator measures trend intensity by telling us where price stands in relation to its 90 trading-day range. A very low number tells us that price is currently at or near 90-day lows, while a higher number tells us that we are near the highs. A value at or near 50 percent tells us that we are at the middle of the currency pair’s 90-day range.

Range High – 90-day closing high.

Range Low – 90-day closing low.

Last – Current market price.

Bias – Based on the above criteria, we assign the more likely profitable strategy for any given currency pair. A highly volatile currency pair (Volatility Percentile very high) suggests that we should look to use Breakout strategies. More moderate volatility levels and strong Trend values make Momentum trades more attractive, while the lowest Vol Percentile and Trend indicator figures make Range Trading the more attractive strategy.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES IS MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION.

OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. Any opinions, news, research, analyses, prices, or other information contained on this website is provided as general market commentary, and does not constitute investment advice. The FXCM group will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance contained in the trading signals, or in any accompanying chart analyses.

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06 May 2013 16:00 GMT