Measuring Volatility in the Foreign Exchange Markets

Volatility is the change in the returns of a currency pair over a specific period, annualized and reported in percentage terms. The larger the number, the greater the price movement over a period of time. There are a number of ways to measure volatility, as well as different types of volatility.

Volatility can be used to measure the fluctuations of a portfolio, or help to determine the price of options on currency pairs. Understanding and learning how to measure volatility in the foreign exchange markets is a must for every serious trader.

Different Types of Volatility

There are two specific types of volatility. What has already happened is known as historical volatility, whereas what market participants think is going to happen is referred to as implied volatility (IV) . Historical volatility tells us how much the market has moved on an annualized basis.

The market’s estimate of how much a currency pair will fluctuate over a certain period in the future is known as implied volatility. Option traders can use a currency volatility index to price options on currency pairs. Implied volatility is generally considered a measure of sentiment. When the currency markets are complacent, implied volatility is relatively low, but when fear infiltrates the market environment, implied volatility rises.

Volatility as Measure of Bounciness

Volatility as a measure of bounciness, is simply a standard deviation of the underlying asset.

In the options world, volatility is quoted as an annualized number. You can calculate a one year, one standard deviation move,by taking the volatility times the underlying price.

For example, if the underlying price was 100 and volatility was 20%, a one standard deviation move would be 20 points, up or down. This would create an expected price range of 80 to 120.

Time Horizons

If you have a different time horizon, we can calculate that as well by adjusting the volatility by using the square root of time. For a one-month period, the standard deviation would be 20% times the square root of 1/12. The square root of 1/12 is 0.289. Therefore, the range from an initial price of 100 would be 94.2 to 105.8 in one month. For a one-week period, the standard deviation would be 20% times the square root of 1/52. A one standard deviation range for a week, would be 97.2 to 102.8.

Implied Volatility is used to Value Currency Options

Implied volatility is a critical component of option valuations. There are two main style of options on currency pairs – a call option and a put option. A call option is the right but not the obligation to purchase a currency pair at a specific exchange rate on or before a certain date. A put option is the right but not the obligation to sell a currency pair at a specific exchange rate on or before a certain date. The exchange rate where the currency pair will be transacted is referred to as the strike price while the date wherein the option matures is called the expiration date.

Forex future options are quoted in two different ways .

(a) Premium Quoted European Style Options : A price is quoted.

(b) Volatility-Quoted options (VQO) allow submission of orders in terms of volatility instead of price. We are not covering VOQ for our training purpose.

Currency Options Pricing model

An options pricing model uses several inputs which include the strike price of the option (which is an exchange rate), the expiration date of the option, the current exchange rate, the interest rate of each currency, as well as the implied volatility of the forex option. The calculation determines the probability that the underlying exchange rate will be above or below a strike price, depending on whether you are generating a price for a call or a put option.

All the inputs for the Black Scholes Pricing model are related to one another and therefore if you know the price of the option, you can back out the implied volatility of the forex option. So, if you see the price of an option (or the bid offer spread of an option), you can use an options pricing model to find the implied volatility of the currency pair.

A simple options calculator will allow you to input a price and find the fx option volatility of a specific currency instrument.

So why would you want to know the historical volatility of a currency pair? One important reason is it can help you manage your risk. Most traders do not sufficiently consider the risks of trading. However, the serious trader understands and incorporates volatility into their trading plan.

Whether you are managing one currency pair or a basket of currency pairs it is helpful to understand the overall risks of your portfolio.

Overall risk within a currency portfolio

Value at Risk (VAR), is a way of describing the risk within a portfolio of currency pairs. The process of analyzing the returns of multiple currency pairs is essential in determining the capital you have at risk.

If you have ever had a situation wherein you have multiple currency positions open at any one time, your risk is very different than having a position open in just one currency pair. What you are attempting to define with VAR is the amount of funds you would lose or gain with a specific movement of your portfolio.

Measuring Risk with Value at Risk (VAR)

Value at Risk can be determined using a few basic methodologies. You can use an analytic solution which uses historical volatility to determine the variances in a portfolio. A second measure is to use simulations.

This means that you look at all the historical paths that were taken over time and simulate the most probable scenario. The more data you have the more likely you will be able to find a solution that is pertinent. Monte Carlo simulation is a popular method for sampling of values in a data series.

Of course there are drawbacks to using VAR as the only strategy to measure market risk. First, there are many assumptions that one can use to define a VAR, which means there is no standard measure. Liquidity plays a role in defining your ability to use VAR as a risk management tool.

If you are running a portfolio of major currency pairs, your liquidity will be different compared to running an emerging market portfolio. One of the assumptions with VAR is that you will be able to exit with specific parameters. VAR works well with assets that are normally distributed and will not see outside movements caused by political unrest or currency manipulation.

VAR also has a relatively narrow definition and does not incorporate other types of risk management challenges such a credit risk, and liquidity risk. The calculation is purely focused on market risk and could provide a false sense of security if used as a standalone measure.

Additionally, VAR shows a trader the greatest adverse effect of a market move on a portfolio. With currency pairs, there are up and down moves which need to be taken into account when measuring the risk of a portfolio.

There are a number of reasons you would want to know the most volatile currency pairs. The first is to determine the risk you are assuming. It is important to know whether an asset has moved 100% in the last year or 10%. Understanding the risk of a currency pair or a basket of currency pairs is imperative to a successful trading strategy. Having a robust entry signal is only helpful if you have a sound risk management strategy.

Implied volatility vs Historical volatility

Implied volatility will provide you with the markets estimate of how much the market will move. Historical volatility is the actual volatility that occurred in the past. Generally, implied volatility is higher than historical volatility.

Implied volatility for currency crosses will generally be higher than the implied volatility of the majors. The most volatile forex pairs are exotic currency pairs which can have volatility numbers that are as extreme as some individual stocks.

Implied volatility can also help you measure sentiment. Traders will associate high level of implied volatility with fear and low levels of implied volatility with complacency. Market extremes usually occur when sentiment is at its highest or lowest levels.

By graphing implied and historical volatility, you have a way of measuring perceived future sentiment as well as actual historical sentiment. This can allow you to see how the markets reacted after an event or before an event occurred. By incorporating volatility into your trading plan, you can enhance your return and fine tune your risk management techniques.