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Forex futures and options sentiment data suggest that the recent US Dollar rally may be the start of a bigger move, pointing to further EURUSD and AUDUSD declines.

A pickup in forex options volatility expectations suggests we may continue to see major moves in the days ahead. Likewise significant, seasonal cycles in forex markets have shown that the month of January tends to set the pace for the full trading year. Thus it will be particularly important to watch what happens in the first week of an especially pivotal month. The DailyFX Research Team has almost universally called for US Dollar strength in 2011.

Watch a presentation on how you can use FX Options risk reversals and this report in your swing trades.

Risk Reversals

EUR/USD

GBP/USD

USD/JPY

USD/CAD

USD/CHF

AUD/USD

NZD/USD

1-Week

55.09%

74.34%

85.37%

34.59%

57.05%

61.45%

58.93%

1-Month

42.50%

66.23%

97.42%

29.56%

51.59%

65.06%

63.47%

3-Month

40.51%

71.43%

94.48%

28.48%

43.48%

64.24%

63.58%

12-Month

30.52%

77.48%

96.75%

26.49%

39.24%

70.63%

66.67%

DailyFX Volatility Index Percentiles

Volatility Index

1 Week

2 Weeks

1 Month

3 Months

1 Year

Indices

52.31%

46.15%

38.46%

32.31%

25.00%

US_Dollar_Rally_Likely_to_Continue_on_FX_Sentiment_body_Picture_1.png, US Dollar Rally Likely to Continue on FX Sentiment

Euro/US Dollar Options Analysis

US_Dollar_Rally_Likely_to_Continue_on_FX_Sentiment_body_Picture_2.png, US Dollar Rally Likely to Continue on FX Sentiment

Our benchmark breakout-style FX Options risk reversals trading system hypothetically closed its EURUSD-short position as of December 30 at a modest loss. Yet a subsequent correction in trader sentiment suggests that the system may once again take a short position through near-term trade. We maintain that the Euro set an important top amidst sentiment extremes, and the subsequently sharp pullback in futures positioning and FX Options risk reversals points to further downside.

We will wait until clarification in sentiment before taking an aggressive short-term stance, but our medium-term bias remains bearish.

British Pound/US Dollar Options Analysis

US_Dollar_Rally_Likely_to_Continue_on_FX_Sentiment_body_Picture_3.png, US Dollar Rally Likely to Continue on FX Sentiment

Recently sharp rallies in the GBPUSD has clouded short-term outlook for the currency pair. Forex futures positioning shows that speculators remain marginally net-short the British Pound, while FX Options risk reversals suggest traders have recently moved towards betting on hedging against GBP rallies. Overall downward momentum leaves our bias somewhat to the downside, but currently unclear sentiment makes short-term forecasts difficult.

US Dollar/Japanese Yen Options Analysis

US_Dollar_Rally_Likely_to_Continue_on_FX_Sentiment_body_Picture_4.png, US Dollar Rally Likely to Continue on FX Sentiment

Our breakout-style risk reversals trading system hypothetically went long USDJPY from November 10 at approximately the 82.30 mark and continues to hold said position. Forex futures positioning has since corrected significantly to the topside, all but confirming an important USDJPY bottom. We accordingly remain bullish the USDJPY until further notice, and indeed several analysts have recently gone long the USDJPY in expectations of further strength.

US Dollar/Canadian Dollar Options Analysis

US_Dollar_Rally_Likely_to_Continue_on_FX_Sentiment_body_Picture_5.png, US Dollar Rally Likely to Continue on FX Sentiment

Substantial Canadian Dollar strength has sent the USDCAD to fresh lows, but FX Options risk reversals have not followed suit and point to a clear divergence in sentiment and price action. Such a divergence does not rule out further short-term weakness, but it suggests that options traders are not betting on or hedging against further USDCAD weakness at these significant lows. Our outlook subsequently remains overall bullish, but our FX Options systems are admittedly not particularly close to taking a long position.

US Dollar/Swiss Franc Options Analysis

US_Dollar_Rally_Likely_to_Continue_on_FX_Sentiment_body_Picture_6.png, US Dollar Rally Likely to Continue on FX Sentiment

A recent sharp rally in the USDCHF has led to a commensurate pullback in FX Options risk reversals, suggesting that traders are beginning to hedge against and bet on USDCHF rallies. That said, Forex Futures positioning shows that speculators have steadily added to their USD-short positions against the Swiss Franc. The mixed sentiment bias leaves us without an especially clear short-term trading forecast.

Australian Dollar/US Dollar Options Analysis

US_Dollar_Rally_Likely_to_Continue_on_FX_Sentiment_body_Picture_7.png, US Dollar Rally Likely to Continue on FX Sentiment

Recently sharp AUDUSD declines have coincided with similarly aggressive shifts in FX Options risk reversals, suggesting that traders have begun betting on and hedging against further weakness. Forex futures positioning shows that speculators had been steadily adding to their AUDUSD-longs through recent trade, which waters down our otherwise-bearish bias. Yet a failure to hold recent post-float highs leaves risks to the downside and warns of further corrections.

New Zealand Dollar/US Options Analysis

US_Dollar_Rally_Likely_to_Continue_on_FX_Sentiment_body_Picture_8.png, US Dollar Rally Likely to Continue on FX Sentiment

The New Zealand dollar continues to underperform its Australian counterpart in both price action and trader sentiment, and our short-term bias remains bearish. Forex futures data shows that speculators have aggressively closed NZDUSD-longs as the pair topped, all but confirming that a reversal was likely. The recently aggressive downward move in risk reversals suggests many have started betting on and hedging against further weakness. Though our benchmark risk reversals systems are not currently short, we remain bearish.

Written by David Rodríguez, Quantitative Strategist for DailyFX.com, drodriguez@dailyfx.com

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