## Forex Volatility - Part 1

AdrianWS Posted 6 May in #Forex #Volatility #Options #Smile #Term Structure #Surface2/33

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**Introduction:**Volatility can be really simple, yet at the same time can become incredibly complicated. Because of this I will try and keep the more complex ideas as simple as possible so that those new to using volatility can begin to learn. What is key to remember Volatility has no influence on direction, it can be both upwards or downwards. But as you'll find out later it can interpreted to show sentiment.

Simply, the volatility of an instrument, whether it an FX pair or the price of gold is its tendency to change in price over time. So in its simplest form you can look at the Average True Range (ATR) of a currency pair to see its recent volatility. Calculated as the (High price - Low price) this can give a broad view of recent moves. One flaw with this is that it cannot be used accurately in a historical context as it shows the "true range" as opposed to the % variation which would be more appropriate

As shown below is a chart of the EURUSD with a 14-rolling day ATR placed in the lower pane, as you can see volatility was clearly high in both the height of the Euro-crisis and during the 08/09 financial crisis.

*EURUSD daily. JForex*

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**Option-Implied (IV) and historical Volatilities:**Another way to examine volatility of a financial security is too look at the options market, using the Black Scholes formula one can determine the "implied volatility" for a defined period. The formula is far too complicated for me to understand and you need a PhD in Mathematics to fully understand it. Thankfully computers have advanced so much that this is not neccesary to use the formula.

Furthermore historical volatility, defined by the average deviation from the average price over a given time period. Both of these two methods combined can be used to analyse the markets.

As shown below, is the option implied and historical volatility for the EUR with regard to a 6-month time period, it shows that at the moment the volatility is significantly suppressed at the moment, partially reflecting the high levels of liquidity in the markets thanks to global central bank easing and partially showing the calming down of the recent few years of the Eurozone crisis.

*EUR 6m IV green, 6m Historical Vol. Thomson Reuters.*

This chart just shows the 3-month IV for the AUD going back to just pre-2008, it shows the huge spike in volatility, but also how at the moment volatility in the AUD is at almost record lows. N.b. It won't stay this low for ever and will be reliant on a a breakout of the 1.01 - 1.06 range, BofA expect this to have occurred by the end of July.

*AUD 3m IV. Thomson Reuters*

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__Volatility Smile:__

The volatility smile shows the respective volatility for various options and times either side of the At-the-money (ATM) level. To the left shows put options and the right shows call options. Sometimes known as the Volatility skew, this visually shows volatility risk to the downside and upside.

In this example there is much more volatility with respect to put options vs. calls. This is commonly referred to as a "reverse skew" and the common explanation for this occurance is that traders are concerned that the market may fall hard over the time period, this is because traders are buying put options as a hedging strategy.

Conversely to this example in the EURUSD is the Volatility smile for the USDJPY, in this case the 3m IV is in a "forward skew"

As you can see this is the opposite to the the reverse skew, and the rational is basically the opposite and currencies are expressed as one currency with respect to another. So you can imagine the JPY/USD would look equivalent to that of the EUR/USD and so traders are hedging themselves against a further decline in the JPY.

While these can't be used to "predict" the future moves, it adds a layer of perspective that is from large institutional traders by way of fear to either upside or downside moves. So in essence these charts both show that traders fear a possible fall in the EUR and JPY vs. the USD over the coming 3 months. Because of this it shows sentiment in the market.

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__Volatility__

**Term Structure:**

Much like the smile, the term structure plots Volatility on the y-axis but in this instance places the Tenor or time. So it shows the volatility from as short as one week to 9 years.

This shows that there is much greater risk for variance in the short term price movements than in 1 year time. After this the volatility follows a normal, theoretical path, that is with longer duration comes higher volatility. Much like that shown in the AUD term structure below;

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**Volatility surface:**

This is a 3-D representation of the two above styles of looking at volatility, fair warning these can look rather complicated but once you become familiar with them, then you can quickly interpret sentiment and risk against duration.

The first surface is for the AUDUSD, this follows a fairly typical slope and gradient, whereby there is relatively little skew in the smile and a fairly linear move in the term structure.

Now lets look at a surface and deduce what it means. Here is the surface for the S&P500, note it is fairly similar to that of the AUD due to the correlation and risk aversion aspects of both the instruments.

So what we can see here is by first looking at the smile aspect of the surface on the bottom left, you can see that the volatility is skewed to puts as opposed to calls, this is seen across all of the Tenor's so we can interpret from this that traders are very fearful of a large move downwards in the S&P 500.

Also there are no particular time periods in the future where volatility is expected to be higher and that as one would expect, increased time = increased volatility.

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__conclusion:__Volatility is an incredibly powerful tool, what is key is that it doesn't show future price movements but it shows trader sentiment better than any other method, be it the CoT report et al.

It can be complicated and this was, maybe surprisingly, the very basic in looking at Forex and Equity volatility. But if you have any question, related to anything in here be sure to ask in the comments below and I'll try to explain it you as quickly as possible.

Many thanks,

Adrian.