Mastering Currency Trading with Implied Volatility Data: A Step-by-Step Guide
If you take a look at the options table we share in our videos, you’ll notice that we have a daily range low and a daily range high for each currency pair. These yellow markers represent the one-day implied volatility range, a crucial tool we’ve demonstrated in our videos. This guide will explain how to access and utilize implied volatility data effectively.
Accessing Implied Volatility Data
The first step is having access to implied volatility data. Providers like Refinitiv and Bloomberg offer a wide range of implied volatility gauges. You can get overnight implied volatility, one-week, one-month, three-month, and six-month options. Each of these provides valuable insights, but if you don’t have access to implied volatility data, this process won’t be of much help.
Personally, I’ve used a variety of these gauges over time and find the most value in using the one-month and one-week implied volatility. While there’s nothing wrong with using other durations, the signals from the one-month volatility data are the most useful compared to higher or lower durations. Once you have your implied volatility data, it’s straightforward to figure out how to use it. But first, let’s discuss why we use it and why we find it so useful.
Why Use Implied Volatility?
Looking at a normal bell distribution curve, we know that price is expected to move within one standard deviation 68% of the time. This means we expect it to move within a specific range 68% of the time or within two standard deviations 95% of the time. Implied volatility gives us a potential standard deviation for price movement based on a specific timeframe.
For example, if the annualized implied volatility for the AUD/CAD pair is 9.2%, it indicates that the options market expects the AUD/CAD to move 9.2% higher or lower from its current level over the next twelve months. This is because implied volatility is annualized. If we return to the bell curve, this means the market believes there’s a 68% chance the AUD/CAD will move up 9.2% or down 9.2% in the next twelve months. The further out the scope, the higher the certainty of this movement.
Converting Annualized Implied Volatility to Daily Range
Implied volatility is an annualized measure, meaning it predicts price movement over the course of the next twelve months. To convert this to a daily range, remember that volatility is proportional to the square root of time. Here’s how to do it:
- Calculate the Square Root of Trading Days:
- There are roughly 252 trading days in a year.
- The square root of 252 is approximately 15.87.
- Divide the Annualized Volatility by the Square Root:
- For AUD/CAD with an annualized volatility of 9.2%, divide 9.2 by 15.87.
- This results in a daily expected move of approximately 0.58%.
- Determine the Daily Range:
- Multiply the spot price (e.g., 0.9037 for AUD/CAD) by the daily expected move (0.0058).
- This gives a daily range of about 52 pips.
The options market predicts a 68% chance that AUD/CAD will move up or down by 52 pips in a day. For a 95% probability, this range doubles to 104 pips.
Using Implied Volatility Levels Around Trading Risk Events
Understanding implied volatility levels is particularly crucial when trading around risk events. During such events, price movements can become stretched, and knowing the implied volatility can help you determine potential profit-taking levels. If you see that the price is moving towards the upper or lower end of the implied volatility range during a risk event, it might be a good indicator that the price is getting stretched and a reversal or correction could be imminent. This can guide you on where to set your take-profit levels to optimize your trading strategy.
For instance, if you’re trading during an economic announcement and the price starts pushing towards the extreme ends of the implied volatility range, it’s a signal that the market might be overreacting. This overreaction often corrects itself, providing a strategic exit point for your trades. This strategy helps in managing risks effectively and ensuring that you are not caught off-guard by sudden market reversals.
Practical Application
Since implied volatility changes constantly, looking at the closing prices and the closing number for the one-month volatility can be more helpful than the constantly moving range during the day. This gives a sense of where the market thought the reasonable range was just a few hours ago, and from there, you can gauge how far the price has deviated from that expected range.
To convert this to a weekly or monthly range:
- Weekly: Use the square root of 52 weeks.
- Monthly: Use the square root of 12 months.
This simple approach helps traders understand market expectations and set realistic stop-loss and profit targets. The implied volatility range based on closing prices offers a snapshot of market sentiment a few hours ago, aiding in risk management.
Conclusion
Using implied volatility data is invaluable for currency traders. By understanding and converting this data, you can better predict market movements and manage risks. Always remember that implied volatility is a dynamic measure, changing as market conditions evolve.
For more detailed guidance and practical trading tips, check out our economic calendar for real-time updates on upcoming risk events. Don’t hesitate to reach out for further assistance. Happy trading!