Do Themes of Yen Weakness, Dollar Strength Have Continuation Potential? Dollar to Focus on Fed Speakers, Euro Needs a Push. Extreme in Euro Speculative Longs Grows, Crude Oil Specs Hit Bids. FTSE Fortifies Important Support, but Has Big Test Ahead. EURUSD - Bullish Case Options Weakened, but Support Still Holding. Quantitative analysis, algorithmic trading, and retail trader sentiment. Options market risk reversals have long been known as a gauge of financial market sentiment, and this article highlights two key strategies in using FX options risk reversals to trade major currency pairs. Using automated trading software we can view the hypothetical performance of such systems and make forward-looking forecasts on major currency pairs. FX Options Risk Reversals: What are they currency how can we use them? In our last Forex Strategy Corner articlewe discussed the importance of volatility expectations in pricing FX options and how to use them in gauging market conditions. FX options risk reversals take volatility analysis one step further and use them not to predict market conditions but as a gauge of sentiment on a specific currency pair. Thus if we compare implied volatility levels across a series of options, we can get a sense for trader sentiment on a direction for a specific currency trading. Volatility smiles most frequently show that traders are willing to pay higher strategies volatility prices as the strike price grows aggressively out of the money. We are subsequently interested in the options shape of the curve; the chart above shows that options traders are paying a significant volatility premium for OTM EURUSD puts versus the equivalent calls. We can options equivalently OTM puts and call with a single number: In our FX Options Weekly Forecast, we use Risk Reversals to gauge trends and shifts in trends for major currency pairs. Yet we have found it is a bit more difficult to use the absolute Risk Reversal number in creating set strategies, as different dynamics across currency pairs complicates strategies of strategy rules. As such, we distill the risk reversal number into a rolling day percentile. Why 90 trading days? A study of the EURUSD finds that such a time period was particularly successful in picking noteworthy tops and bottoms for much of and The chart below shows that the EURUSD set several strategies tops and bottoms when the day FX Options risk reversal hit and 0 percent, respectively. Thus we will work this concept into two distinct strategies that have historically had a fair deal of success across different currency pairs. Using such software we can determine the historical profitability and theoretical viability of both of our proposed strategies. When the Risk Reversal hits its bottom 5 th percentile in the past 90 days, buy. If it hits its top 5 th percentile, trading. Close the long position if the Risk Reversal hits its 45 th percentile or above. Cover the short position if the Risk Reversal hits its 55 th percentile or below. Results for Forex Options Risk Reversals Range Trading Strategy. As the EURUSD chart suggests above, this strategy has historically performed quite well in the EURUSD. Through the pictured time frame, risk reversal extremes in either direction provided accurate signals for reversal and great timing tools. Yet a major caveat with these results is that the same principles do not work across all currency pairs. This range trading strategy has performed relatively well in the EURUSD, USDJPY, and USDCHF pairs over the past several years of hypothetical results. One can speculate as to why this may be the case, but it seems relatively clear that we would have needed a different approach to catch major swings in this often-volatile currency pair. Thus we are left to discuss our second trading strategy: When the Risk Reversal currency its bottom 5 th percentile or below as it relates to previous 90 days, go short. If it hits its top 5 th percentile or above, go long. Close the long position if the Risk Reversal options its 70 th percentile or below. Cover the short position if trading risk reversal hits its 30 th percentile or above. Results for Forex Options Risk Reversals Breakout Trading Strategy. Given that the British Pound performed especially poorly with the Range Trading system, it should be relatively little surprise to see that it is an outperformer with trading dissimilar Breakout-style trading strategy. And though past performance is never a guarantee of currency results, such consistent gains suggest that there is more to such gains than pure coincidence. The sudden downturn in performance in the AUDUSD equity curve emphasizes strategies nothing ever works all of the time, currency certainly these strategies were developed with the benefit of hindsight. Yet the relatively intuitive rules behind the strategies should hold some truth. Attempting to quantify exact trading parameters is consistently difficult, and developing something that works well as a completely automated system is far from a straightforward task. Risk reversals nonetheless show some promise using different trading styles currency the major currency pairs, and this suggests that we can use it as another confirming indicator in timing medium-to-longer term swing trades. View updates on FX Options Risk Reversals and these two trading styles every Wednesday on DailyFX. DailyFX provides forex news and technical analysis on the trends that influence the global currency markets. 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Forex Trading Strategy Session: Why I don't like Trading FX Options
Forex Trading Strategy Session: Why I don't like Trading FX Options
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