Forex Analysis: Volatility Forecast to Jump in New Year

Article Summary: The US Dollar finds itself at month-to-date highs, but low volatility through year-end makes further moves unlikely. We will instead shift focus to the New Year as we have seen an important shift in volatility expectations.

DailyFX PLUS System Trading Signals –The last week of the trading year is unlikely to force major US Dollar (ticker: USDOLLAR) moves, but FX options traders show fears of big moves headed into the New Year.

The Dow Jones FXCM Dollar Index trades near month-to-date highs on important USD strength versus the Australian Dollar and Japanese Yen, but such momentum is unlikely to continue into the final week of the trading year as volatility tumbles. Yet it is significant to note that forex options traders are now pricing in stronger FX moves through the first quarter of 2012—a sign that lower volatility may not be here to stay.

We will not place any new trades until the New Year, as low liquidity and potentially difficult trading conditions worsen the potential reward to risk of trading. Indeed, our sentiment-based trading systems have all been shut down for the year.
Going forward, however, we will likely switch our trading biases towards our trend-following “Tidal Shift/Momentum2” trading system as well as volatility-friendly “Breakout Opportunities”/Breakout2 strategies. Past performance is not indicative of future results, but the “Tidal Shift” system has done well through recent months of strong trends in Japanese Yen and US Dollar pairs.

Volatility expectations point to larger moves in the New Year, and we will trade accordingly.

DailyFX Individual Currency Pair Conditions and Trading Strategy Bias

Market Conditions:A noteworthy bounce in forex options market volatility expectations shows that many traders expect stronger currency moves into the New Year, and we will look to shift our trading biases accordingly. Although still low by historical standards, it seems as though traders are predicting stronger moves into January and beyond. Volatility tends to cluster—if January is volatile, February is likely to be similar.

Thus we will watch with great interest how markets start the year and trade accordingly. Seasonal tendencies show that the month of January can quite often set the pace for the entire year.

DailyFX Volatility Indices in 2012
— Written by David Rodriguez, Quantitative Strategist for DailyFX.com
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Definitions
Volatility Percentile – The higher the number, the more likely we are to see strong movements in price. This number tells us where current implied volatility levels stand in relation to the past 90 days of trading. We have found that implied volatilities tend to remain very high or very low for extended periods of time. As such, it is helpful to know where the current implied volatility level stands in relation to its medium-term range.
Trend – This indicator measures trend intensity by telling us where price stands in relation to its 90 trading-day range. A very low number tells us that price is currently at or near 90-day lows, while a higher number tells us that we are near the highs. A value at or near 50 percent tells us that we are at the middle of the currency pair’s 90-day range.
Range High – 90-day closing high.
Range Low – 90-day closing low.
Last – Current market price.
Bias – Based on the above criteria, we assign the more likely profitable strategy for any given currency pair. A highly volatile currency pair (Volatility Percentile very high) suggests that we should look to use Breakout strategies. More moderate volatility levels and strong Trend values make Momentum trades more attractive, while the lowest Vol Percentile and Trend indicator figures make Range Trading the more attractive strategy.
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