Implied volatility is one of the most tried and true methods for objectively measuring expected volatility in the spot market. Derived from currency options with different maturities, implied volatilities are used to help predict potential movements in the spot market and is one of the most popular strategies of systems traders and other professional hedge funds.
At its most fundamental, the basic and intuitive interpretation of this implied data is often the most telling for traders. Taken alone, a steady rise in the longer-term implied volatility (the red line) is indicative of a strengthening trend; while inversely, a decline often reveals that a period of range or consolidation in spot is ahead or already in place. Additionally, the histogram or spread between the shorter and longer-term implied volatilities (the blue colored bars) tells a different perspective. As the histogram rises, volatility is expected to pick up faster in the near future relative to the longer-term range. Ultimately, this increases the probability of a breakout scenario in the underlying currency.
EURUSD
Implied volatilities on EURUSD options have fallen significantly off of their multi-month peaks, as a general recovery in risk appetite and a slowdown in price moves have lowered options premiums on aggregate. Such developments suggest that the extreme price moves we have grown accustomed to as of late will die down through short-term trading—especially as the shorter-dated implieds are trading 55 basis points below their longer-term counterparts. What this tells us is that markets are expecting volatility to be lower in the coming week than in the month as a whole.
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