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Forex Options: How to Make Use of Implied Volatility in Trading Forex

By Forex Fraud:

Forex options can be exceptionally useful for a forex trader, but there’s no single way of using them in trading. You can use them as a kind of hedging mechanism, or to reduce the overall exposure of your account to a currency pair. You may use them to limit your downside. And you may use them for purposes unrelated to trading itself, as indicators of market sentiment and positioning, for completing the spot market data depicted by the forex trading software. But whatever you do with them, you’ll eventually find that implied volatility is one of the most important concepts that you should be knowledgeable about in order to make use of options.

Options pricing is a complex subject, and requires a degree of familiarity with derivatives, and calculus in general. But there is one simple fact about options that is easily understood and useful for trader’s purposes: it is that of all the items that contribute to the establishment of an option’s price according to the most common and popular models, implied volatility is the only one that is a prediction. All the other factors, such as the strike price, interest rates, and the term of the option are well-known at the moment the contract is written, but volatility is not, and that is why it is so important in any options pricing strategy.

IV (as implied volatility is often termed by market practitioners), is simply the estimate inherent in a option contract about the future volatility of the underlying. Let’s assume, for example, that there are two option contracts with exactly the same expiry data, and payout, but very different prices: the justification for this divergence is to be sought in volatility. Simply stated, a higher volatility will result in a higher likelihood of the strike price being hit, and will as such command a higher premium. If a trader expects volatility to be higher, he’ll be willing to pay the higher premium, and vice versa.

Implied volatility is an exceptionally important subject in options analysis, but it is also relevant for forex traders as well. Rising implied volatility over a theoretical continuation of the historic volatility, for instance, suggest that options traders are on the whole convinced that the market may keep driving the trend higher. Conversely, falling volatility may imply that a period of consolidation in a currency pair may ensue, possibly preceding a reversal.

Volatility is examined and studied by traders for a wide variety of strategies, and also for hedging purposes. The volatility smile, delta hedging, convexity, are some of the concepts that are intimately related to volatility, and can be exploited by forex traders for spot trading purposes.

So get your forex demo account, and try to test some of the assumptions of the options market in trading. Soon you too will have your own toolbox of great strategies based on the dynamics of the vast options market.

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