Price Breaks and Currency Volatility Smiles

Another way to use price break charting with currency option trading is to apply it to volatility smiles. The term volatility smile refers to the shape of the curve generated by the implied volatility at different delta strike prices. These smiles are considered important in currency

Line Break Serious I Last Price:-0.8925 Next Reve...

11/18/2008 12/15/2008 1/8/2009 1/29/2009 2/20/2009

Figure 7.6 EURJPY Risk Reversal Curve

Source: Bloomberg markets. Theoretically, there should be a simple smile where the market has no bias in direction. But markets can be skewed, and when you see a volatility smirk leaning to one direction, it shows that sentiment is biased for calls or puts. The trader's challenge is to interpret the volatility smile. Is it leading or lagging? Is it overextended? By using price break charting in relationship to volatility smiles, the trader can get a handle on whether the smile shape is also confirming a reversal.

For example, consider the volatility smile in Figure 7.8a, which shows option opinion leaning to the call side. An option trader looking at this chart may consider placing calls on the EURUSD pair. An alternative view would be to consider the smile to be overextended and buy a put playing the opposite view. Here is where price break charts can make a difference and augment the decision process. The price break chart of the EURUSD (Figure 7.8b) shows that there is a reversal break downward, with two consecutive new day lows. It is probable that a trader using these price break results would conclude that the smile was not likely to last, because the price break direction did not confirm it.

Consider the example of the currency pair AUDUSD. In Figure 7.9a, we see a volatility smile that is heavily skewed to the put side. Traders call this a smirk. In fact, it is very severe. Based on this chart, a trader could conclude that going with the option opinion was the way

Line Break Serious I Last Price:-2.5

Figure 7.7 Price Break Version of Figure 7.6

Source: Bloomberg

Figure 7.7 Price Break Version of Figure 7.6

Source: Bloomberg

5P 10P 15P 20P 25P 30P 35P 40P 45P ATM 45C 40C 35C 30C 25C 20C 15C 10C 5C

Figure 7.8a Volatility Smile of EURUSD

Source: Bloomberg




Line Break Serious ■ Last Price 1.4811

Next Reverse I Volume Series

8/17/2009 .4082





Figure 7.8b Price Break Chart of EURUSD

Source: Bloomberg to go, and so he would place a put on the AUDUSD. However, the price break chart in Figure 7.9b shows that the AUD is still in a long sequence of new highs. In this case, the smile is opposite the trend direction and may be leading it. But there are interesting clues in the price break chart. Notice that the size of the price break high sequences are getting short, almost flat. This indicates a tired trend. If the trader was to put on a put anticipating a reversal, he would count back 3 lines from

Figure 7.9a AUDUSD Smirk

Source: Bloomberg

Figure 7.9a AUDUSD Smirk

Source: Bloomberg

Line Break Series ■ Last Price 0.876 Line High Line Low I Volume Serious

3/25/2009 5/5/2009 6/1/2009

Figure 7.9b AUDUSD Three-Line Break Chart

Source: Bloomberg


the latest low and use that point as a nearby strike price. On Figure 7.9b that point is .8624. Therefore .86 would be a desireable strike location for a put.

Chapter Note

1. McGraw-Hill, 1999.


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