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FX Volatility at Five-Year Lows - How do we Trade?

FX Volatility at Five-Year Lows - How do we Trade?

2012-08-20 16:00:00
David Rodriguez, Head of Product
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DailyFX Individual Currency Pair Conditions and Trading Strategy Bias

forex_strategy_outlook_range_trading_favored_body_Picture_1.png, FX Volatility at Five-Year Lows - How do we Trade?

DailyFX PLUS System Trading SignalsAn important lull in FX market volatility expectations suggests that the US Dollar (ticker: USDOLLAR) may remain within a tight trading range against major counterparts, and we continue to favor low-volatility range trading strategies amidst slow market conditions.

FX options markets show 1-Week volatility expectations have tumbled towards record lows moves since the onset of global financial crises in 2007/2008, and such low expectations point to range trading in the week ahead. Real trades data shows that most traders have historically done well in periods of low volatility, and indeed it seems as though trading in current market conditions is somewhat akin to eating your vegetables as a child—it may not be especially enjoyable, but might be good for your trading account.

We see little choice but to favor low-volatility range trading strategies amidst current market conditions. In concrete terms this means that we put little faith in any sharp Euro/US Dollar declines or rallies—major pairs remain unlikely to break significantly in either direction.

For our sentiment-based trading strategies, this means that the “Congestion Opportunities/Range2” strategy will be favored across most pairs, while we will treat any “Breakout Opportunities/Breakout2” trades with caution. We will need to see an important swing in market conditions in order to change our strategy biases.

Market Conditions:

FX Options prices show that 1-week volatility expectations have tumbled towards record lows in an especially run of FX trading. There’s always the risk that such low levels warn of complacency and an imminent breakout, but betting on a sharp turnaround in trend is especially difficult. We’ll continue to monitor volatility readings going forward and make note of any important changes.

forex_strategy_outlook_range_trading_favored_body_Picture_2.png, FX Volatility at Five-Year Lows - How do we Trade?

Low volatility has directional implications for the US Dollar (ticker: USDOLLAR), as the correlation between the DailyFX 1-Month Volatility Index and the Dow Jones FXCM Dollar Index trades near record strength. The USD stands to fall further across the board as volatility remains in a clear downtrend.

forex_strategy_outlook_range_trading_favored_body_Picture_3.png, FX Volatility at Five-Year Lows - How do we Trade?

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

Meet the DailyFX team in Las Vegas at the annual FXCM Traders Expo, November 2-4, 2012 at the Rio All Suite Hotel & Casino. For additional information regarding the schedule, workshops and accommodations, visit the FXCM Trading Expo website.

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. Low Forex Volatility Favors Dollar Weakness, Range Trading

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 monthly 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 monthly 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.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

DISCLOSURES