Volatility As A Guide For The Week Ahead
Pepperstone | Feb 11, 2019 15:58
Originally published by Pepperstone
Certainly a quiet day on the market, with some focus on the re-open of the Chinese mainland markets, where we can see the CSI 300 playing catch-up with a gain of 1.3%. The Japanese equity market is closed.
We can see ranges have been on the tight side today, and nobody has been prepared to stamp down any authority. I have no doubt that will change as we head through the week, with trade relations slap bang at the epicentre of concerns. Robert Lighthizer and Steven Mnuchin are in Beijing for high levels talks, with any findings subsequently passed to Trump, who will no doubt analyse while on Airforce One on his adventures to Vietnam to meet Kim Jong-Un. Axios are also reporting that Trump will hold a Summit with Xi in March, so, it seems likely there will be an extension of the current trade truce.
To put context around the impact tariffs have had so far. Late last week the Institute of International Finance (IIF) put out a working paper with research that reviewed over 7000 goods currently subject to Trump’s tariffs. Importantly, their findings highlight a significant decline in the level of imports (to the US) of the $50b of goods currently subject to tariffs of 25%. They found no real impact on the demand for goods currently taxed at 10% - this is the $200b basket of goods involved in the current truce.
The issue with trade tariffs is that we already see signs of damage to China’s trade, and we should see further signs of this in Thursday’s China January trade balance. The consensus is calling for a 10.7% decline in China’s imports and a 3.2% fall in exports, and again, it is further evidence that China’s Q1 GDP (reported 17 April) will be closer to 6%. We always look the US economic data, and of course, how that drives changes in Fed policy, but it is China that is the most important economy to watch this year in my opinion.
h2 Volatility as a guide for the week ahead/h2It's hard to state how important volatility is as a central input for trading and whether running a fundamental strategy, Expert Advisor (EA), or even a discretionary technical strategy, we can use implied or realised volatility to assist with our assessment of risk and subsequently position sizing.
Of course, many of us are use realised (or historic) volatility (vol) in our trading every day, utilising indicators such as the ATR (Average True Range) or Bollinger Bands. However, I prefer to use implied vol, which is forward-looking and reflects expectations of where volatility in that instrument might be headed over a specific time frame.
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As we can see in the chart, I have laid out one-day, and one-week implied volatility (IV), the net change (in vols) on the day. And, after inputting into the Black-Scholes formula, which I do through Bloomberg terminal, we can assess the move implied over that period, and this is the most important consideration. So, rather than look in the rear view mirror, why not let the market tell you how they see things and use the implied move as a guide on how much risk you can take.
For example, the implied move in GBP/USD on today's session is 78-pips, which is certainly elevated and suggests cable should have the most significant move in G10 FX.
I trade off 4-hour and daily charts, so if I put a stop loss on the trade say 40-points away the chance of getting stopped out is high. We can see that GBP/USD is pricing in a 146-point move in cable over the week, and granted there is time premium involved. However, if I often hold positions for a week, then, in theory, I would put my stop at least 146-points away from the market. Now that I know my risk, I can then assess the contract size to achieve correct position sizing.
Remember, volatility is directionally agnostic so that the 146-point move could occur in either direction.
It’s interesting that despite a 1.7% move lower in the past five days in AUDUSD is pricing a 68-pip move on the week, with 1-week IV still below the 12-month average of 8.34%. This, despite Aussie home loans, NAB business conditions and Westpac Consumer confidence and China data due through the week.
What we can see though is that overnight IV has spiked up today, presumably as China’s mainland markets have re-opened.
Another variable to look at is risk reversals (RR). I have touched on these before, but RRs look at the skew of put to call volatility. As we can see below AUD/USD one-week RR sit at -0.65x. This effectively tells me that options traders have the most bearish sentiment on the AUD than other G10 currency and are the most bullish on JPY. One can assume from this that the most bearish sentiment is on AUD/JPY.
So, an interesting backdrop by which to work in and we can use the implied vol as a guide for the expected move, so keep an eye on the calendar and see how this vol level feeds into the context of the data.
On another note, I have closed out of my EUR/CHF trade, but am eyeing the USD index closely here. As I suggested last week, the US is showing signs of economic divergence, and we can see on the daily price breaking higher here.
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