One of the most important risk factors when trading financial assets and their derivatives is the actual and historical volatility of the underlying asset that impacts the implied volatility used to price option derivative contracts.
Most options also have an implied volatility range within which they trade, which in turn allows options traders to take a view on implied volatility itself since it is a market-determined quantity that tends to revert to its mean value over time. Technical traders can use the implied volatility indicator to get a sense of what sort of actual volatility options traders expect over the future timeframe covered by the option contract.
If you’d like more information on implied volatility, what it measures and how to use it in the forex market to enhance your profits, then read on.
What is Implied Volatility?
To understand implied volatility, you first need to get a grasp on what volatility means. Volatility is a measure of the valuation swings seen in financial markets, and increased volatility is associated with greater market risk for traders holding an asset.
The more volatility that options traders expect over a future timeframe, the higher the prices they are going to charge to sell options that expire at the end of that timeframe. Options have limited downside risk and are often used by traders to hold positions in risky markets, so demand and prices of options tend to rise when market swings look probable. Options can also be used by those who wish to hedge their exposures to the underlying assets in high-risk markets.
The volatility implied by options prices, usually known as implied volatility, tends to reflect actual volatility in the underlying asset, as well as options traders’ expectations for swings in the underlying asset’s value during the option’s tenor. As a result, implied volatility tends to rise and fall as the risk of future market swings waxes and wanes over time.
Implied volatility is also one of the key parameters that options traders need to input into an option pricing model to obtain a particular option’s theoretical price or fair value.
In general, stock options traders will use the Black-Scholes options pricing model to price stock options, while currency options traders will use the Garman-Kohlhagen options pricing model for pricing forex options on currency pairs. Both models require implied volatility to compute an option’s fair value.
If an option’s price is already known, which can be the case when options are traded on exchanges, then the implied volatility corresponding to that price can also be calculated using those same option pricing models.
Implied volatility is most often traded and quoted among options traders for options with at-the-money strike prices that correspond to the underlying asset’s current value. An implied volatility curve can be quoted and plotted for any asset that options are traded on to see how options traders are viewing the risk of market swings in the future.
This implied volatility curve can be positive sloping, flat or inverted. The curve’s shape depends on the various risk factors occurring during each tenor that are expected to cause market swings.
Implied volatilities can also vary considerably within an option series for a particular tenor. This situation usually happens during strong trends and causes the implied volatilities for a given tenure to appear skewed.
If an underlying market is trending in a highly directional manner, then the implied volatility tends to be higher for options with strike prices likely to be crossed as the trend progresses. In contrast, implied volatility tends to be lower for options with strike prices unlikely to be crossed by the trend.
Another phenomenon commonly seen with implied volatility curves for a particular option series is known as the smile. In a directionally neutral market, this shape arises because the wings that include deep in and out-of-the-money options on both sides of the prevailing asset price have little time value, and so they are not very sensitive to implied volatility.
Options in the wings thus need to be offered at prices determined using higher implied volatilities to keep the bid-offer option spread the same as for at-the-money options that have comparatively more time value. The implied volatility bids for options might also rise slightly for options in the wings versus for at-the-money options, but not as much as the implied volatility offers rise for options in the wings.
Historical Volatility vs. Implied Volatility
Historical volatility is a statistical measure of the market swings that have occurred over a given past timeframe. In the forex market, historical volatility is usually expressed as the annualized single standard deviation of exchange rates. Historical volatility thus gives you a sense of how much a currency pair’s exchange rate has deviated from its average exchange rate over a particular period of time.
As discussed in the previous section, implied volatility is a market-determined parameter used to obtain a fair value price for currency options that are related to perceived future market risk and levels of supply and demand for a particular option series and strike price. The level of implied volatility for a particular option tenor or expiration date also reflects the risk that options traders have in selling an option expiring at the end of that tenor.
Both historical and implied volatility can be used by forex traders as a measure of market risk for a particular currency pair, but they relate to risk in different timeframes, with historical looking at the past and implied looking to the future.
This timeframe difference and how forex traders can use each risk measure can be illustrated by two examples:
- Historical volatility: Consider the case where the 1-month historical volatility for EUR/USD is 10% computed on a daily close basis. This would tell a trader that over the past month, the annualized standard deviation of closing exchange rate swings for EUR/USD has been 10%.
- Implied volatility: Consider the case where 1-month implied volatility was 10% for EUR/USD, then that would tell a forex trader that currency options market makers presently expect the historical volatility over the coming 1-month time period to be around 10%.
What Implied Volatility Measures in the Foreign Exchange Market
Implied volatility in the forex market measures levels of supply and demand for currency options, as well as the level of currency option market makers’ collective expectations for future market swings in a particular currency pair. Implied volatility has several important uses for forex and currency options traders as follows.
Indicating Technical Support and Resistance Levels
Forex traders can use implied volatility in various trading strategies since it can help them use statistics to identify possible regions of support and resistance. Since the major currency pairs tend to exhibit mean-reverting characteristics, forex traders can use implied volatility trading ranges to generate forex trading signals that allow them to buy low and sell high with greater confidence.
Reflects Market Risk and Uncertainty
In the foreign exchange market, implied volatility is a forward-looking measure of the risk of market swings and can also reflect the uncertainty prevailing in the market for a currency pair.
Helps Market Makers Price an Entire Series of Options
Forex option market makers use the market-determined implied volatility for a particular expiration date to price the entire series of currency options that expire on that same date. This greatly simplifies their task of providing currency option prices to customers and other market makers.
Lets Traders Take a View on Future Risk
Forex traders and option market makers can also take a view on implied volatility that can boost their trading profits if it turns out to be correct. Implied volatility thus adds another dimension to forex trading that can be encapsulated in a currency option position.
For example, a trader bullish on implied volatility for EUR/USD might buy a 2-month at-the-money straddle in EUR/USD that involves purchasing both a call and a put with the same strike price at the 2-month forward rate for EUR/USD.
Advantages of Implied Volatility as a Forex Signal
The benefits of using implied volatility as a forex signal are significant since this market-determined and quoted metric gives you insight into the currency options market’s expectations for future exchange rate swings.
Also, since the major currency pairs tend to exhibit mean-reverting characteristics, forex traders can use implied volatility trading ranges to generate forex trading signals.
For example, this process could involve computing a theoretical trading range from the implied volatility using the assumption that the exchange rate will remain within a one-standard-deviation move. The market has a 68% statistical probability of remaining within that range over the timeframe covered by the implied volatility quote.
If the exchange rate moves to the upper level of this one standard deviation trading range, then the statistical chances are 84% that it will then fall, but only 16% that it will continue to increase. Conversely, if the exchange rate drops to the bottom of the one standard deviation trading range, then an 84% statistical probability of a subsequent rise exists, with only a 16% chance of a continued decline.
Should You Use Implied Volatility to Trade Forex?
Implied volatility is typically used by fairly advanced forex traders who choose to incorporate currency options into their trading strategies. Learning how to trade implied volatility can add an extra dimension to your forex trading alternatives that can help you profit from the view that market risk will increase over a certain timeframe.
You can learn how to delta hedge long options positions to make extra money with limited downside risk if implied volatility seems cheap. Some strategic traders prefer to sell options when implied volatility seems high, especially if they think the options will not be exercised against them based on their directional view.
Even if you do not wish to use currency options when you trade forex, you can still keep an eye on implied volatilities to assess future market risk based on what the currency options market is presently discounting for an upcoming time period. This activity can help inform your position sizing decisions too.
Implied volatility can also suggest theoretical levels of support and resistance that any forex trader can use, perhaps in combination with momentum indicators like the Relative Strength Index (RSI), to get a sense of when a market move could be overdone and hence statistically ripe for a reversal.
Frequently Asked Questions
What is a good implied volatility number?
Implied volatility is a market-determined quantity that measures future risk and tends to revert to a mean value over time. The actual level of this average value and what it implies depends on which underlying asset or currency pair is involved.
Why do traders use implied volatility?
Traders use implied volatility to price options, determine possible levels of support and resistance on a statistical basis and to measure the future risk of market swings.
What is better: high or low implied volatility?
If you prefer to trade in a risky market, then one with high implied volatility might suit you best, but if you prefer calmer trading conditions, then select a market with low implied volatility. Also, if you are trading options, then you might want to sell a relatively high implied volatility level and buy a relatively low implied volatility level if you think the market is respectively over or undervaluing the risk of market swings. This might also make sense since implied volatility tends to revert to a mean value over time.
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