How to Trade Forex Volatility

Markets become volatile when traders expect big changes but are not sure how much, how soon or in which direction markets will change. Bloomberg writes about how shock and awe have come to the market.

Traders who complained all summer about markets stuck in a zombie state are getting what they wanted, and probably will be for a while.

Eruptions of volatility this big rarely go away quickly. By one measure, the selloff ripping equities represents the sixth most violent rupture to market calm in history, with the S&P 500 Index’s drop of 2.5 percent exceeding its daily move in the prior month by a factor of 10. Every time that happened in the past, turbulence took its time petering out.

Forex traders will be wise to watch what happens as the volatility in the stock market may flow over into Forex. Then the question will be how to trade Forex volatility.

Volatility Brings Profits

We wrote recently about Forex volatility profits.

With increased Forex volatility profits can rise for traders who are tuned in to the foreign currency market. The world is a chaotic place today with political unrest across North Africa and the Middle East, outright civil war and NATO intervention in Libya, and the devastating earthquake and tsunami that recently hit Japan. At such times Forex volatility profits the prepared. Volatility comes from uncertainty. Successful trading comes from a firm knowledge of the fundamentals of the currencies that one trades and a clear view of market direction so far as technical analysis will supply it.

Times of great market volatility are also times to apply Forex options.

Currency speculators use Forex options to limit their risk. No matter how much a market surprise might take prices in the opposite direction that traders anticipate, Forex options traders never lose more than the price of the options contract. This assumes that the options contract is out of the money before the trader can bail out of his trade. If the trader pays attention to the market he can commonly exit a trade while the contract still has some value.

Volatility Index

A useful indicator of Forex volatility is the CBOE EuroCurrency ETF Volatility Index.

The CBOE EuroCurrency Volatility Index (”Euro VIX”, Ticker – EVZ) measures the market’s expectation of 30-day volatility of the $US/Euro exchange rate by applying the VIX methodology to options on the CurrencyShares Euro Trust (Ticker – FXE).

Like other VIX benchmarks, EVZ uses options spanning a wide range of strike prices.

Euro VIX is just one in a series of new volatility indexes based on new asset classes, marking the next generation of VIX benchmarks. CBOE currently calculates the CBOE Crude Oil Volatility Index (OVX) based on United States Oil Fund (USO) option prices; and also the CBOE Gold Volatility Index (GVZ) based on SPDR Gold Shares (GLD) options.

FXE is an exchange-traded fund (ETF) that holds Euro on-demand deposits in Euro-denominated bank accounts. As such, the performance of FXE is intended to reflect the $US/Euro exchange rate, less fund expenses. Following is a chart comparing FXE prices with the spot Euro exchange rate.

Like the VIX for stocks this index provides a useful view of how volatile the Forex market is.