Picture this; you’re on the verge of opening a new trade. The indicators you’ve been patiently awaiting – averages crossing, RSI hitting 80, or whatever else – are finally moving into perfect alignment. You expel a huge sigh of relief and your order is engaged. But then, instead of the solid trend you were expecting to see, you get instead pretty much nothing. A market that is just barely muddling through. You’re dragged right into a stagnant market leaving you scratching your head and thinking, “what did I miss?”
It doesn’t make sense. You were diligent; you did your research and you calibrated your indicators and still you got nothing. No movement at all; just a range. It’s frustrating beyond belief. And what about the times you set up that “great” stop loss that the market abruptly sliced right through. Does that scenario sound familiar? Sure. It happens to everybody.
So, what did you miss? In a word: Volatility.
The Wisdom of Derivatives
Of course, we all know about volatility; it’s the measurement of price fluctuations. Or more plainly, it’s how fast a price moves. It is volatility (or its absence) that entangles a pair within a range, often swiftly and mercilessly. And while the average spot trader may believe volatility comes at the market’s whim that is generally not the case.
In the spot market volatility may seem a force majeure, but in derivatives trading, volatility is the essence, especially with options. Generally, options trading is based on volatility and more specifically, on implied volatility. And implied volatility is the expected volatility as embodied in the price of the options.
Implied Volatility Made Simple
Before you begin to get stressed out, rest assured, this is not a lesson in options trading. Rather, it’s a lesson on how to predict volatility and use it in your trade. Implied volatility is the suggested volatility as extracted from the price of Put and Call options on a specific stock or currency pair. If you’ve no experience with options trading this might seem tricky. In fact, that couldn’t be farther from the truth. Thanks to volatility indicators we can measure implied volatility on various FX pairs.
The CBOE FX Volatility Index
The CBOE exchange, where many FX options are traded, is also where you’d find a convenient series of volatility indicators. For example, the EUVIX measures implied volatility on the Euro, the JYVIX does the same for the Yen, etc. Reading an index is simple; when the index is high, volatility is expected to be high and vice versaSource : CBOE
Two Dimensions to Watch
When analyzing the volatility index for a specific currency there are two dimensions to consider. The first dimension is pretty straightforward; it is the level of the index. If the level is high or rising then you should take that fact into account. That’s especially important if you’re planning to place a rather small stop loss. The EUVIX (and its ilk) can help you understand what level of volatility currently exists under current market conditions.
The second dimension denotes the “zones” of volatility. That is if the index hits a certain level or zone it tends to either fall back or bounce. In the graph above, note that the EUVIX tends to ease around the 13-14 zone and rise around the 11-12 zone. Unlike the spot market, with volatility indices it’s more of a zone you’re aiming for, not an exact spot.
Source : CBOE
How would you use a volatility index?
It’s a straightforward process. When the index approaches or is above the zone of maximal volatility, you can expect volatility to fall. In that case, if you’re riding a trend, prepare for some slowdown in momentum. Conversely, if the index is below the area of minimal volatility, it’s likely that volatility will rise from here onwards. If the pair is range bound and you’re waiting for a break that could be good news. Bad news could also be good news if it triggers a stop loss close to the market price. What’s important is that you will be cognizant of where to expect volatility. Also, understand that the maximum and minimum volatility areas change over periods. That means you need to watch how the index responded in a similar timeframe (hourly, daily, weekly, etc). Of course, as well all know, nothing in this world is a certainty, least of all in the world of trading. Even so, monitoring volatility, both in the long term and short, is crucial for trading success.