Currency Traders focus on technical patterns and price action to strategize their next trades. Yet, there is another component of analysis that provides a different diagnostic lense:sentiment. Sentiment analysis includes a broad range of information that conveys whether expectations about direction are bullish or bearish. While the study of sentiment analysis is fairly new and the science of it is yet emerging, the volatility smile remains a key component to generate clues to the future direction of a currency. Even though many traders do not look at volatility smiles, it can make a difference in choosing direction. Lets take a closer look.
The chart below shows a Volatility smile for XAUUSD, Gold spot. We can see that it is skewed to the Put side because the implied volatility of Puts at a Delta 25 distance is greater than the implied volatility of calls at that same Delta 25. It is bearish as it costs more to buy protective Puts on Gold than it costs to buy protective Calls. Keep in mind the duration is 1 Month.
Knowing this skew, the trader should lean to a bearish direction,because the options sentiment , expressed in the volatility surface is skewed to the bearish direction as well. If the skew was extremely bearish, or for that matter, extremely bullish, the trade might consider that it was contrarian as an indicator as extremes in any measure wont last.
Lets look at some volatility smiles for the EURUSD, and the USDJPY.
The EurUSD volatility surface clearly shows a strong bearish skew. The Implied volatility of the Calls at a 25 Delta is 10.4 in contrast to the Implied volatility of Puts at 25 Delta of 11.7. The message is don’t bet on the EURUSD going bullish for any length of time.
Consider the GBPUSD, which of course has had its huge bearish implosion. What is the sentiment about its direction as expressed in the Volatility surface? The 3 month volatility surface for the GBPUSD is clearly skewed to the bearish side. The Implied volatility of Puts at the 25 Delta point is 10.1. In contrast the Implied volatility of Calls at the 25 Delta point is 11.5.
We can see that both the EURUSD and the GBPUSD are bearish in the sentiment outlook. If that is the case, we should expect a near Volatility smile for the EURGBP, since both are about equally bearish. A Volatility smile has no skew and it means the market sentiment is neutral. We are not surprised by the nearly perfect Volatility smile for the EURGBP.
The take-away here is that forex traders need to look beyond the dimension of basic technical analysis and apply sentiment analysis to get an edge on future direction.
Abe Cofnas is the Fundamental Market Strategist for MTI. He has over 25 year experience in forex, options, and futures trading. He is the author of 4 books on trading published by Wiley and Bloomberg press.
