What is FOREX

Forex (FOReign EXchange market) is an inter-bank market that took shape in 1971 when global trade shifted from fixed exchange rates to floating ones. This is a set of transactions among forex market agents involving exchange of specified sums of money in a currency unit of any given nation for currency of another nation at an agreed rate as of any specified date. During exchange, the exchange rate of one currency to another currency is determined simply: by supply and demand – exchange to which both parties agree. The simple sense of Forex (Forex currency exchange, Foreign Exchange) is simultaneous purchase and sale of the currency or the exchange of one country's currency for the one of another country. The world currencies do not have a fixed exchange rate and are always fluctuating being traded in the currency pairs like Euro/Dollar, Dollar/Yen an others. 85% of daily trades are taken by major currencies trading. Investments usually deal with 4 major pairs: Euro against US dollar, US dollar against Japanese yen, British pound against US dollar, and US dollar against Swiss franc or EUR/USD, USD/JPY, GBP/USD, and USD/CHF used to sign these pairs accordingly. These major pairs are considered as Forex market's "blue chips". You will not receive any dividends on the currencies. Well known "buy low - sell high" gives the profit for currency trades. In case you have a forecast that one currency would get higher to another you can exchange the second one for the first one and wait for the profit. If you are lucky to see the trades following your forecast you can make an opposite transaction and to exchange currencies back gaining the profit. Forex transactions are carried out by Forex brokerage companies, also known as major banks dealers. Forex market is worldwide and your European colleagues may make a transaction with Japanese traders when it's time for you to sleep in the North America. There are 3 shifts for the major institutions to work in due to 24-hours a day activity of the Forex market. It's possible to ask for overnight execution for take-profit and stop-loss orders of the client. Prices in the Forex market fluctuate without any dramatic changes unlike stock market where considerable gaps are likely to be seen. There isn't any problems entering and exit the market due to its daily turnover of about $1.2 trillion. Forex market can not ever be forced to stop. The transactions were carried out even in 2001, on September, 11th. Foreign exchange market (also called Forex of FX to shorten the name) is the oldest market in the world. It is also seen to be the largest one. Being currencies' primary market working 24-hours a day, Forex is also the largest market with highest liquidity. This is an interbank market carrying out spot (or cash) transactions. The currency futures market, to be compared with Forex is traded only 1% as much. Forex market doesn't have any exchange center unlike the stock market. Forex trading seem to go after the sun around the world, from banks of the United States to other parts of the world like Australia, New Zealand, the Far East or Europe and back to the US some time later. High minimum amount of transaction and strict financial requirements used to make this interbank market unavailable for small speculators. The only dealers of currency markets were banks, huge-amount speculators and largest currency dealers. They had an ultimate access to this market dealing with lots of primary exchange rates of the world currencies, the market with an extremely high liquidity along with an unusually strong nature of trends. Nowadays small traders have an opportunity to purchase the small lots (units), as a result of the large inter-bank units being split by market maker brokers like eToro, at the amount they like. The traders of any size like small companies and individual speculators have an access to the market at the same price fluctuations and exchange rates which only large players used to enjoy recently. Market makers monitor the rates so that produce their profit on the difference of rates at which the currency was bought and sold. Foreign Exchange Market has an acronymic name Forex. It has the largest size and the liquidity throughout the world nowadays. Forex daily transactions are carried out at the common amount from 1 to 3 trillion dollars. There is no stock market that is able to deal with a comparable amount of money. This enormous market is like the dangerous sea where you can meet lots of sharks and dangerous waters but at the same time it is the only one where two weeks of trading can hypothetically bring you $1,000,000 out of $1,000 of initial investment. This is certainly hypothetically because a lot of newbie traders deal with their trades as gambling, that surely bring them to having nothing in the end. You should always keep the phrase "be careful!" in your mind. This market would give you its profit possibilities only if you learn the basic things hard and make lots of demo trading. The statistics is that as much as 95% of traders come to losing their money at Forex, 5% have profit and less than 1% of traders make large fortune at Forex. You shouldn't produce, sell or advertise anything trading at Forex. Your assets are your knowledge, experience and a small amount of cash. This market is a platform for banks, transnational corporations and individual traders to change the currencies they possess into other ones. This is the spot Forex market. At this market you can trade with up to 1:400 leverage which means that you'll get $400 on your account for each dollar invested. So, you can trade with the $400,000 sum having invested $1,000 onto your account. Still, lots of experienced traders consider such leverage dangerous and won't get started with it. Though, if you know how ho use such high leverage it will do you only good. But this is the place to stop speaking about the basic things. Keep reading these articles if you want to be aware of how this market has occurred and some of its historical matters. Now it is time to speak about the strategies and the way of making money at Forex some traders use. First we should say that the things that work in one case do not certainly work in another. The fact is that currency trading surely means risk. Still, there are a number of strategies for the newbie to use to be the winner. Forex trading may seem very easy but it is not. Your high today earnings may turn into considerable losses even of your starting capital tomorrow. Newbie traders are likely to make the same mistakes several times. Here is a list of such typical mistakes

Identifying Trending & Range-Bound Currencies

The overall forex market generally trends more than the overall stock market. Why? The equity market, which is really a market of many individual stocks, is governed by the micro dynamics of particular companies. The forex market, on the other hand, is driven by macroeconomic trends that can sometimes take years to play out. These trends best manifest themselves through the major pairs and the commodity block currencies. Here we take a look at these trends, examining where and why they occur. Then we also look at what types of pairs offer the best opportunities for range-bound trading.
The Majors
There are only four major currency pairs in forex, which makes it a quite easy to follow the market. They are:
* EUR/USD - euro / U.S. dollar
* USD/JPY - U.S. dollar / Japanese yen
* GBP/USD - British pound / U.S. dollar
* USD/CHF - U.S. dollar / Swiss franc
It is understandable why the United States, the European Union and Japan would have the most active and liquid currencies in the world, but why the United Kingdom? After all, as of 2005, India has a larger GDP ($3.3 trillion vs. $1.7 trillion for the U.K.), while Russia's GDP ($1.4 trillion) and Brazil's GDP ($1.5 trillion) almost match U.K.'s total economic production. The explanation, which applies to much of the forex market, is tradition. The U.K. was the first economy in the world to develop sophisticated capital markets and at one time it was the British pound, not the U.S. dollar, that served as the world's reserve currency. Because of this legacy and because of London's primacy as the center of global forex dealing, the pound is still considered one of the major currencies of the world.
The Swiss franc, on the other hand, takes its place amongst the four majors because of Switzerland's famed neutrality and fiscal prudence. At one time the Swiss franc was 40% backed by gold, but to many traders in the forex market it is still known as "liquid gold". In times of turmoil or economic stagflation, traders turn to the Swiss franc as a safe-haven currency.
The largest major pair - in fact the single most liquid financial instrument in the world - is the EUR/USD. This pair trades almost $1 trillion per day of notional value from Tokyo to London to New York 24 hours a day, five days a week. The two currencies represent the two largest economic entities in the world: the U.S. with an annual GDP of $11 trillion and the Eurozone with a GDP of about $10.5 trillion.
Although U.S. economic growth has been far better than that of the Eurozone (3.1% vs.1.6%), the Eurozone economy generates net trade surpluses while the U.S. runs chronic trade deficits. The superior balance-sheet position of the Eurozone and the sheer size of the Eurozone economy has made the euro an attractive alternative reserve currency to the dollar. As such, many central banks including Russia, Brazil and South Korea have diversified some of their reserves into euro. Clearly this diversification process has taken time as do many of the events or shifts that affect the forex market. That is why one of the key attributes of successful trend trading in forex is a longer-term outlook.
Observing the Significance of the Long Term
To see the importance of this longer-term outlook, take a look at Figure 1 and Figure 2, which both use a three-simple-moving-average (three-SMA) filter. Figure 1 - Charts the EUR/USD exchange rate from Mar 1 to May 15, 2005. Note recent price action suggests choppiness and a possible start of a downtrend as all three simple moving averages line up under one another. Figure 2 - Charts the EUR/USD exchange rate from Aug 2002 to Jun 2005. Every bar corresponds to one week rather than one day (as in Figure 1). And in this longer-term chart, a completely different view emerges - the uptrend remains intact with every down move doing nothing more than providing the starting point for new highs.
The three-SMA filter is a good way to gauge the strength of trend. The basic premise of this filter is that if the short-term trend (seven-day SMA) and the intermediate-term trend (20-day SMA) and the long-term trend (65-day SMA) are all aligned in one direction, then the trend is strong.
Some traders may wonder why we use the 65 SMA. The truthful answer is that we picked up this idea from John Carter, a futures trader and educator, as these were the values he used. But the importance of the three-SMA filter not does lie in the specific SMA values, but rather in the interplay of the short-, intermediate- and long-term price trends provided by the SMAs. As long you use reasonable proxies for each of these trends, the three-SMA filter will provide valuable analysis.
Looking at the EUR/USD from two time perspectives, we can see how different the trend signals can be. Figure 1 displays the daily price action for the months of March, April and May 2005, which shows choppy movement with a clear bearish bias. Figure 2, however, charts the weekly data for all of 2003, 2004 and 2005, and paints a very different picture. According to Figure 2, EUR/USD remains in a clear uptrend despite some very sharp corrections along the way.
Warren Buffett, the famous investor who is well known for making long-term trend trades, has been heavily criticized for holding onto his massive long EUR/USD position which has suffered some losses along the way. By looking at the formation on Figure 2, however, it becomes much clearer why Buffet may have the last laugh.
Commodity Block Currencies
The three most liquid commodity currencies in forex markets are USD/CAD, AUD/USD and NZD/USD. The Canadian dollar is affectionately known as the "loonie", the Australian dollar as the "Aussie" and the New Zealand Dollar as the "kiwi". These three nations are tremendous exporters of commodities and often trend very strongly in concert with the demand for each their primary export commodity.
For instance, take a look at Figure 3, which shows the relationship between the Canadian dollar and prices of crude oil. Canada is the largest exporter of oil to U.S. and almost 10% of Canada's GDP comprises the energy exploration sector. The USD/CAD trades inversely, so Canadian dollar strength creates a downtrend in the pair. Figure 3 - This chart displays the relationship between the loonie and price of crude oil. The Canadian economy is a very rich source of oil reserves. The chart shows that as the price of oil increases, it becomes less expensive for a person holding the Canadian dollar to purchase U.S.dollars.
Although Australia does not have many oil reserves, the country is a very rich source of precious metals and is the second-largest exporter of gold in the world. In Figure 4 we can see the relationship between the Australian dollar and gold. Figure 4 - This chart looks at the relationship between the Aussie and gold prices (in U.S. dollars). Note how a rally in gold from Dec 2002 to Nov 2004 coincided with a very strong uptrend in the Australian dollar.
Crosses Are Best for Range
In contrast to the majors and commodity block currencies, both of which offer traders the strongest and longest trending opportunities, currency crosses present the best range-bound trades. In forex, crosses are defined as currency pairs that do not have the USD as part of the pairing. The EUR/CHF is one such cross, and it has been known to be perhaps the best range-bound pair to trade. One of the reasons is of course that there is very little difference between the growth rates of Switzerland and the European Union. Both regions run current-account surpluses and adhere to fiscally conservative policies.
One strategy for range traders is to determine the parameters of the range for the pair, divide these parameters by a median line and simply buy below the median and sell above it. The parameters of the range is determined by the high and low between which the prices fluctuate over a give period. For example in EUR/CHF, range traders could, for the period between May 2004 to Apr 2005, establish 1.5550 as the top and 1.5050 as the bottom of the range with 1.5300 median line demarcating the buy and sell zones. (See Figure 5 below). Figure 5 - This charts the EUR/CHF (from May 2004 to Apr 2005), with 1.5550 as the top and 1.5050 as the bottom of the range, and 1.5300 as the median line. One range-trading strategy involves selling above the median and buying below the median.
Remember range traders are agnostic about direction (for more on this, see Trading Trend or Range?). They simply want to sell relatively overbought conditions and buy relatively oversold conditions.
Cross currencies are so attractive for the range-bound strategy because they represent currency pairs from culturally and economically similar countries; imbalances between these currencies therefore often return to equilibrium. It is hard to fathom, for instance, that Switzerland would go into a depression while the rest of Europe merrily expands. The same sort of tendency toward equilibrium, however, cannot be said for stocks of similar nature. It is quite easy to imagine how, say, General Motors could file for bankruptcy even while Ford and Chrysler continue to do business. Because currencies represent macroeconomic forces they are not as susceptible to risks that occur on the micro level - as individual company stocks are. Currencies are therefore much safer to range trade.
Nevertheless, risk is present in all speculation, and traders should never range trade any pair without a stop loss. A reasonable strategy is to employ a stop at half the amplitude of the total range. In the case of the EUR/CHF range we defined in Figure 5, the stop would be at 250 pips above the high and 250 below the low. In other words if this pair reached 1.5800 or 1.4800, the trader should stop him- or herself out of the trade because the range would most likely have been broken.
Interest Rates - the Final Piece of the Puzzle
While EUR/CHF has a relatively tight range of 500 pips over the year shown in Figure 5, a pair like GBP/JPY has a far larger range at 1800 pips, which is shown in Figure 6. Interest rates are the reason there's a difference.
The interest rate differential between two countries affects the trading range of their currency pairs. For the period represented in Figure 5, Switzerland has an interest rate of 75 basis points (bps) and Eurozone rates are 200 bps, creating a differential of only 125 bps. However, for the period represented in Figure 6, however, the interest rates in the U.K are at 475 bps while in Japan - which is gripped by deflation - rates are 0 bps, making a whopping 475 bps differential between the two countries. The rule of thumb in forex is the larger the interest rate differential, the more volatile the pair. Figure 6 - This charts the GBP/JPY (from Dec 2003 to Nov 2004). Notice the range in this pair is almost 1800 pips!
To further demonstrate the relationship between trading ranges and interest rates, the following is a table of various crosses, their interest rate differentials and the maximum pip movement from high to low over the period from May 2004 to May 2005.

Using Currency Correlations To Your Advantage

To be an effective trader, understanding your overall portfolio's sensitivity to market volatility is important. But this is particularly so when trading forex. Because currencies are priced in pairs, no single pair trades completely independently of the others. Once you know about these correlations and how they change, you can take advantage of them to control over your portfolio's exposure.
Defining Correlation
The reason for the interdependence of currency pairs is easy to see: if you were trading the British pound against the Japanese yen (GBP/JPY pair), for example, you are actually trading a kind of derivative of the GBP/USD and USD/JPY pairs; therefore, GBP/JPY must be somewhat correlated to one if not both of these other currency pairs. However, the interdependence among currencies stems from more than the simple fact that they are in pairs. While some currency pairs will move in tandem, other currency pairs may move in opposite directions, which is in essence the result of more complex forces.
Correlation, in the financial world, is the statistical measure of the relationship between two securities. The correlation coefficient ranges between -1 and +1. A correlation of +1 implies that the two currency pairs will move in the same direction 100% of the time. A correlation of -1 implies the two currency pairs will move in the opposite direction 100% of the time. A correlation of zero implies that the relationship between the currency pairs is completely random.
Reading The Correlation Table
With this knowledge of correlations in mind, let's look at the following tables, each showing correlations between the major currency pairs for the month of March 2005.

The upper table above shows that over the month of March (one month) EUR/USD and AUD/USD had very strong positive correlation of 0.94. This implies that when the EUR/USD rallies, the AUD/USD will also rally 94% of the time. Over the longer term (three months), though, the correlation is slightly weaker (0.47).
By contrast, the EUR/USD and USD/CHF had a near-perfect negative correlation of -0.99. This implies that 99% of the time, when the EUR/USD rallies, USD/CHF will undergo a selloff. This relationship even holds true over longer periods as the correlation figures remain relatively stable.

Yet correlations do not always remain stable. Take USD/CAD and NZD/USD, for example. With a coefficient of -0.94, they had a strong negative correlation over the past year, but the relationship deteriorated over March 2005 for a number of factors, including the Reserve Bank of New Zealand's intentions to resume rate hikes, and political instability in Canada.
Correlations Do Change
It is clear then that correlations do change, which makes following the shift in correlations even more important.Sentiment and global economic factors are very dynamic and can even change on a daily basis.Strong correlations today might not be in line with the longer-term correlation between two currency pairs.That is why taking a look at the six-month trailing correlation is also very important.This provides a clearer perspective on the average six-month relationship between the two currency pairs, which tends to be more accurate.Correlations change for a variety of reasons, the most common of which include diverging monetary policies, a certain currency pair’s sensitivity to commodity prices, as well as unique economic and political factors.
Here is a table showing the six-month trailing correlations that EUR/USD shares with other pairs:

Calculating Correlations Yourself
The best way to keep current on the direction and strength of your correlation pairings is to calculate them yourself. This may sound difficult, but it's actually quite simple.
To calculate a simple correlation, just use a spreadsheet, like Microsoft Excel. Many charting packages (even some free ones) allow you to download historical daily currency prices, which you can then transport into Excel. In Excel, just use the correlation function, which is =CORREL(range 1, range 2). The one-year, six-, three- and one-month trailing readings give the most comprehensive view of the similarities and differences in correlation over time; however, you can decide for yourself which or how many of these readings you want to analyze.
Here is the correlation-calculation process reviewed step by step:
1. Get the pricing data for your two currency pairs; say they are GBP/USD and USD/JPY
2. Make two individual columns, each labeled with one of these pairs. Then fill in the columns with the past daily prices that occurred for each pair over the time period you are analyzing
3. At the bottom of the one of the columns, in an empty slot, type in =CORREL(
4. Highlight all of the data in one of the pricing columns; you should get a range of cells in the formula box.
5. Type in comma
6. Repeat steps 3-5 for the other currency
7. Close the formula so that it looks like =CORREL(A1:A50,B1:B50)
8. The number that is produced represents the correlation between the two currency pairs
Even though correlations do change, it is not necessary to update your numbers every day, updating once every few weeks or at the very least once a month is generally a good idea.
How To Use It To Manage Exposure
Now that you know how to calculate correlations, it is time to go over how to use them to your advantage.
First, they can help you avoid entering two positions that cancel each other out, For instance, by knowing that EUR/USD and USD/CHF move in opposite directions nearly 100% of time, you would see that having a portfolio of long EUR/USD and long USD/CHF is the same as having virtually no position - this is true because, as the correlation indicates, when the EUR/USD rallies, USD/CHF will undergo a selloff. On the other hand, holding long EUR/USD and long AUD/USD is similar to doubling up on the same position since the correlation is so strong.
Diversification is another factor to consider. Since the EUR/USD and AUD/USD correlation is traditionally not 100% positive, traders can use these two pairs to diversify their risk somewhat while still maintaining a core directional view. For example, to express a bearish outlook on the USD, the trader, instead of buying two lots of the EUR/USD, may buy one lot of the EUR/USD and one lot of the AUD/USD. The imperfect correlation between the two different currency pairs allows for more diversification and marginally lower risk. Furthermore, the central banks of Australia and Europe have different monetary policy biases, so in the event of a dollar rally, the Australian dollar may be less affected than the Euro, or vice versa.
A trader can use also different pip or point values for his or her advantage. Lets consider the EURUSD and USDCHF once again. They have a near-perfect negative correlation, but the value of a pip move in the EURUSD is $10 for a lot of 100,000 units while the value of a pip move in USDCHF is $8.34 for the same number of units. This implies traders can use USDCHF to hedge EURUSD exposure.
Here's how the hedge would work: say a trader had a portfolio of one short EUR/USD lot of 100,000 units and one short USD/CHF lot of 100,000 units. When the EUR/USD increases by ten pips or points, the trader would be down $100 on the position. However, since USDCHF moves opposite to the EURUSD, the short USDCHF position would be profitable, likely moving close to ten pips higher, up $83.40. This would turn the net loss of the portfolio into minus $16.60 instead of minus $100. Of course, this hedge also means smaller profits in the event of a strong EUR/USD sell-off, but in the worst-case scenario, losses become relatively lower.
Regardless of whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to be aware of the correlation between various currency pairs and their shifting trends. This is powerful knowledge for all professional traders holding more than one currency pair in their trading accounts. Such knowledge helps traders, diversify, hedge or double up on profits.
Summary
To be an effective trader, it is important to understand how different currency pairs move in relation to each other so traders can better understand their exposure. Some currency pairs move in tandem with each other, while others may be polar opposites. Learning about currency correlation helps traders manage their portfolios more appropriately. Regardless of your trading strategy and whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to keep in mind the correlation between various currency pairs and their shifting trends.

Bond Spreads: A Leading Indicator For Forex

The global markets are really just one big interconnected web. We frequently see the prices of commodities and futures impact the movements of currencies, and vice versa. The same is true with the relationship between currencies and bond spread (the difference between countries' interest rates): the price of currencies can impact the monetary policy decisions of central banks around the world, but monetary policy decisions and interest rates can also dictate the price action of currencies. For instance, a stronger currency helps to hold down inflation, while a weaker currency will boost inflation. Central banks take advantage of this relationship as an indirect means to effectively manage their respective countries' monetary policies.
By understanding and observing these relationships and their patterns, investors have a window into the currency market, and thereby a means to predict and capitalize on the movements of currencies.
What Does Interest Have to Do With Currencies?
To see how interest rates have played a role in dictating currency, we can look to the recent past. After the burst of the tech bubble in 2000, traders went from seeking the highest possible returns to focusing on capital preservation. But since the U.S. was offering interest rates below 2% (and going even lower), many hedge funds and those who had access to the international markets went abroad in search of higher yields. Australia, with the same risk factor as the U.S., offered interest rates in excess of 5%. As such, it attracted large streams of investment money into the country and, in turn, assets denominated in the Australian dollar.
These large differences in interest rates led to the emergence of the carry trade, an interest rate arbitrage strategy that takes advantage of the interest rate differentials between two major economies, while aiming to benefit from the general direction or trend of the currency pair. This trade involves buying one currency and funding it with another, and the most commonly used currencies to fund carry trades are the Japanese yen and the Swiss franc because of their countries' exceptionally low interest rates. The popularity of the carry trade is one of the main reasons for the strength seen in pairs such as the Australian dollar and the Japanese yen (AUD/JPY), the Australian dollar and the U.S. dollar (AUD/USD), the New Zealand dollar and the U.S. dollar (NZD/USD), and the U.S. dollar and the Canadian dollar (USD/CAD).
However, it is difficult for individual investors to send money back and forth between bank accounts around the world. The retail spread on exchange rates can offset any additional yield they are seeking. On the other hand, investment banks, hedge funds, institutional investors and large commodity trading advisors (CTAs) generally have the ability to access these global markets and the clout to command low spreads. As a result, they shift money back and forth in search of the highest yields with the lowest sovereign risk (or risk of default). When it comes to the bottom line, exchange rates move based upon changes in money flows.
The Insight for Investors
Individual investors can take advantage of these shifts in flows by monitoring yield spreads and the expectations for changes in interest rates that may be embedded in those yield spreads. The following chart is just one example of the strong relationship between interest rate differentials and the price of a currency.
Notice how the blips on the charts are near-perfect mirror images. The chart shows us that the five-year yield spread between the Australian dollar and the U.S. dollar (represented by the blue line) was declining between 1989 and 1998. This coincided with a broad sell-off of the Australian dollar against the U.S. dollar.
When the yield spread began to rise once again in the summer of 2000, the Australian dollar responded with a similar rise a few months later. The 2.5% spread advantage of the Australian dollar over the U.S. dollar over the next three years equated to a 37% rise in the AUD/USD. Those traders who managed to get into this trade not only enjoyed the sizable capital appreciation, but also earned the annualized interest rate differential. Therefore, based on the relationship demonstrated above, if the interest rate differential between Australia and the U.S. continued to narrow (as expected) from the last date shown on the chart, the AUD/USD would eventually fall as well.
This connection between interest rate differentials and currency rates is not unique to the AUD/USD; the same sort of pattern can be seen in USD/CAD, NZD/USD and the GBP/USD. Take a look at the next example of the interest rate differential of New Zealand and U.S. five-year bonds versus the NZD/USD.
The chart provides an even better example of bond spreads as a leading indicator. The differential bottomed out in the spring of 1999, while the NZD/USD did not bottom out until the fall of 2000. By the same token, the yield spread began to rise in the summer of 2000, but the NZD/USD began rising in the early fall of 2001. The yield spread topping out in the summer of 2002 may be significant into the future beyond the chart. History shows that the movement in interest rate difference between New Zealand and the U.S. is eventually mirrored by the currency pair. If the yield spread between New Zealand and the U.S. continued to fall, then one could expect the NZD/USD to hit its top as well.

Using Options Tools To Trade Foreign-Exchange Spot

Delta, gamma, risk reversals and volatility are concepts familiar to nearly all options traders. However, these same tools used to trade currency options can also be useful in predicting movements in the underlying, which in foreign exchange (FX) is the cash or spot product. In this article, we look at how volatility can be used to determine upcoming market activity, how delta can be used to calculate the probability of spot movements, how gamma can predict trading environments and how risk reversals are applicable to the cash market.
Using Volatility to Forecast Market Activity
Option volatilities measure the rate and magnitude of the changes in a currency's price. Implied option volatilities on the other hand measure the expected fluctuation of a currency’s price over a given period of time based upon historical fluctuations. Volatility calculations typically involve the historic annual standard deviation of daily price changes.
Option volatility information is readily available. IFR Markets publishes real-time volatility data on the FXCM news plug-in. The plug-in only shows current volatilities, so for forecasting market activity traders will need to keep a journal tracking historical implied volatilities.
In using volatility to forecast market activity, the trader needs to make certain comparisons. Although the most reliable comparison is implied versus actual, the availability of actual data is limited. Alternatively, comparing historical implied volatilities are also effective. One-month and three-month implied volatilities are two of the most commonly benchmarked time frames used for comparison (the numbers below represent percentages).
Source: IFR Market News Plug-in
Here is what the comparisons indicate:
* If short-term option volatilities are significantly lower than long-term volatilities, expect a potential breakout.
* If short-term option volatilities are significantly higher than long-term volatilities, expect reversion to range trading.
Typically in range-trading scenarios, implied option volatilities are low or declining because in periods of range trading, there tends to be minimal movement. When option volatilities take a sharp dive, it can be a good signal for an upcoming trading opportunity. This is very important for both range and breakout traders. Traders who usually sell at the top of the range and buy at bottom, can use option volatilities to predict when their strategy might stop working - more specifically, if volatility contracts become very low, the likelihood of continued range trading decreases.
Breakout traders, on the other hand, can also monitor option volatilities to make sure that they are not buying or selling into a false breakout. If volatility is at average levels, the likelihood of a false breakout increases. Alternatively, if volatility is very low, the probability of a real breakout increases. These guidelines generally work well, but traders also have to be careful. Volatilities can have long downward trends (as they did between June and Oct 2002) during which time volatilities can be misleading. Traders need to look for sharp movements in volatilities, not a gradual one.
The following is a chart of USD/JPY. The green line represents short-term volatility, the red line long-term volatility and the blue line price action. The arrows with no labels are pointing to periods when short-term volatility rises significantly above long-term volatility. You can see such divergence in volatility tends to be followed by periods of range trading. The ‘1M implied’ arrow is pointing to a period when short-term volatility dips below long-term volatility. At price action above that, a breakout occurs when short-term volatility reverts back towards long-term volatility.
Using Delta to Calculate Spot Probabilities
What Is Delta?
Options price can be seen as a representation of the market’s expectation of the future distribution of spot prices. The delta of an option can be thought of roughly as the probability of the option finishing in the money. For example, given a one-month USD/JPY call option struck at 104 with a delta of 50, the probability of USD/JPY finishing above 104 one month from now would be approximately 50%.
Calculating Spot Probabilities
With information on deltas, one can approximate the market’s expectation of the likelihood of different spot levels over time. When the probability of the spot finishing above a certain level, call-option deltas are used. Similarly when the probability of spot finishing below a certain level, put-option deltas are used.
The key to calculating expected spot levels is using conditional probability. Given two events, A and B, the probability of A and B occurring is calculated as follows:
P(A and B) = P(A)*P(B|A)
In words, the probability of A and B occurring is equal to the probability of A times the probability of B given the occurrence of A.
Here is the formula applied to the problem of calculating the probability that spot will touch a certain level:
P(touching and finishing above spot level) = P(touching spot level) * P(finishing above spot | touched spot level)
In words, the probability of spot touching and finishing above a certain level (or delta) is equal to the probability of spot touching that level times the probability of spot finishing above a certain level given that is has already touched that level.
Given options prices and corresponding deltas, this probability calculation can be used to get a general idea of the market’s expectations of various spot levels. The rule-of-thumb this methodology yields is that the probability of spot touching a certain level is roughly equivalent to two times the delta of an option struck at that level.
Using Gamma to Predict Trading Environments
What Is Gamma?
Gamma represents the change in delta for a given change in the spot rate. In trading terms, players become long gamma when they buy standard puts or calls, and short gamma when they sell them. When commentators speak of the entire market being long or short gamma, they are usually referring to market makers in the interbank market.
How Market Makers View Gamma
Generally, options market makers seek to be delta neutral - that is, they want to hedge their portfolios against movement in the underlying spot rate. The amount by which their delta, or hedge ratio, changes is known as gamma.
Say a trader is long gamma, meaning he or she has bought some standard vanilla options. Assume they are USD/JPY options. If we further assume that the delta position of these options is $10 million at USD/JPY 107, the trader will need to sell $10 million USD/JPY at 107 in order to be fully insulated against spot movement.
If USD/JPY rises to 108, the trader will need to sell another $10 million, this time at 108, as the total delta position becomes $20 million. What happens if USD/JPY goes back to 107? The delta position goes back to $10 million, as before. Because the trader is now short $20 million, he or she will need to buy back $10 million at 107. The net effect then is a 100-pip profit, selling a 108 and buying at 107.
In sum, when traders are long gamma, they are continually buying low and selling high, or vice versa, in order to hedge. When the spot market is very volatile, traders earn a lot of profits through their hedging activity. But these profits are not free, as there is a premium to own the options. In theory, the amount you make from delta hedging should exactly offset the premium. Whether or not this is true in practice depends on the actual volatility of the spot rate.
The reverse is true when a trader has sold options. When short gamma, in order to hedge, the trader must continually buy high and sell low - thus he or she loses money on the hedges, in theory the exact same amount earned in options premium through the sales.
Why Is Gamma Important for Spot Traders?
But what relevance does all this have for regular spot traders? The answer is that spot movement is increasingly driven by what goes on in the options market. When the market is long gamma, market makers as a whole will be buying spot when it falls and selling spot when the exchange rate rises. This behavior can generally keep the spot rate in a relatively tight range.
When the market is short gamma, however, the spot rate can be prone to wide swings as players are either continually selling when prices fall, or buying when prices rise. A market that is short gamma will exacerbate price movement through its hedging activity. Thus:
* When market makers are long gamma, spot generally trades in a tighter range.
* When market makers are short gamma, spot can be prone to wide swings.
Using Risk Reversals to Judge Market Positioning
What Are Risk Reversals?
Risk reversals are a representation of the market’s expectations on the exchange-rate direction. Filtered properly, risk reversals can generate profitable overbought and oversold signals.
A risk reversal consists of a pair of options, a call and a put, on the same currency, with the same expiration (one month) and sensitivity to the underlying spot rate. Risk reversals are quoted in terms of the difference in volatility between the two options. While in theory these options should have the same implied volatility, in practice they often differ in the market. A positive number indicates that calls are preferred to puts and that the market is expecting a move up in the underlying currency. Likewise, a negative number indicates that puts are preferred to calls and that the market is expecting a move down in the underlying currency.
Risk reversals can be seen as having a ‘market polling function’. A positive risk-reversal number implies that more market participants are voting for a rise in the currency than for a drop. Thus, risk reversals can be used as a substitute for gauging positions in the FX market.
How Can Risk Reversals Be Used to Predict Spot-Currency Movement?
While the signals generated by a risk-reversal system will not be completely accurate, they can specify when the market is bullish or bearish.
Risk reversals convey the most information when they are at relatively extreme values. These extreme values are commonly defined as one standard deviation beyond the averages of positive and negative values. Therefore we are looking at values one standard deviation below the average of negative risk-reversal figures, and values one standard deviation above the average of positive risk-reversal figures.
When risk reversals are at these extreme values, they give off contrarian signals - when the entire market is positioned for a rise in a given currency, it makes it that much harder for the currency to rally, and that much easier for it to fall on negative news or events. A large positive risk-reversal number implies an overbought situation, while a large negative risk-reversal number implies an oversold situation. The buy or sell signals produced by risk reversals are not perfect, but they can convey additional information used to make trading decisions.
Example: GBP/USD Here we see risk reversals can generate reasonably accurate signals at extreme values:
Summary
There are many tools used by seasoned options traders that can also be useful to trading spot FX. Volatility can be used to forecast market activity in the cash component through comparing short-term versus longer term implied volatilities. Delta can help estimate the probability of the spot rate reaching a certain level. And gamma can predict whether spot will trade in a tighter range if it is vulnerable to wider swings. Risk reversals are a representation of the market's expectations on exchange-rate direction. If filtered properly, risk reversals can be used to gauge market sentiment and determine overbought and oversold conditions.