There are many different ways that traders can determine whether a currency pair is range trading or trending. Of course, many people do it visually, but having set rules will help to keep traders out of trends that may be fading or to prevent traders from getting into a range trade in the midst of a possible breakout. Table 7.2 outlines some of rules that I look for in order to classify a currency pairs trading environment.
Table 7.2 Trend/Range Trading Rules
Trade Rules Indicators
Range • ADX < 20
• Decreasing Implied volatility
• Risk reversals near choice or flipping between favoring calls and puts
Bollinger bands, ADX, options
Trend • ADX > 25
• Momentum consistent with trend direction
• Risk reversals strongly bid for put or call
Moving averages, ADX, options, momentum
Range Look for:
ADX (Average Directional Index) Less Than 20 The average directional index is one of the primary technical indicators used to determine the strength of a trend. When ADX is less than 20, this suggests that the trend is weak, which is generally characteristic of a range-bound market. An ADX less than 20 and trending downward provides a further conformation that the trend not only is weak, but will probably stay in a range trading environment for a while longer.
Decreasing Implied Volatility There are many ways to analyze volatility. What I like to do is actually track short-term versus long-term volatility. When short-term volatility is falling, especially alter a burst above long-term volatility, it is usually indicative of a reversion to range trading scenarios. Volatility usually blows out when a currency pair experiences sharp, quirk moves. It contracts when ranges are narrow and the trading is very quiet in the markets. The lazy mans version of the way I track volatility is Bollinger bands, which provide a fairly decent measure for determining volatility conditions. A narrow Bollinger band suggests that ranges are small and there is low volatility in the markets while wide Bollinger bands are reflective of large ranges and a highly volatile environment. In a range trading environment, we are looking for fairly narrow Bollinger bands ideally in a horizontal formation similar to the USD/JPY chart in Figure 7.2.
Risk Reversals Flipping between Calls and Puts A risk reversal consists of a pair of options, a call and a put, on the same currency. Risk reversals have both the same expiration (one month) and the same sensitivity to the underlying spot rate.
They are quoted in terms of the difference in volatility between the two options.
While in theory these options should have the same implied volatility, in practice:
these volatilities often differ in the market. Risk reversals can be seen as having a market polling function. A number strongly in favor of calls or puts indicates that the market prefers calls over puts. The reverse is true if the number is strongly in favor of puts versus calls. Thus, risk reversals can be used as a substitute for gauging positions in the FX market. In an ideal environment, far out-of-the-money calls and puts should have the same volatility. However, this is rarely the case since there is generally a sentiment bias in the markets that is reflected in risk reversals. In range- bound environments, risk reversals tend to flip between favoring calls and puts at
nearly zero (or equal), indicating that there, is indecision among bulls and bears and there is no strong bias in the markets.
Figure 7.2 USD/JPY Bollinger Band Chart (Source: eSignal. www.eSignal.com)
What Does a Risk Reversal Table Look Like? Affording to the risk reversals shown in Table 7.3, we can see that the market is strongly favoring yen calls (JC) and dollar puts over the long term. EUR/USD short-term risk reversals are near zero, which is what you are looking for when profiling a range-hound environment. The most readily available free resource that I know of for up-to-date risk reversals is the IFR news plug-in which can be found on the FX Trading Station at www.fxcm.com.
TABLE 7.3 Risk Reversals 14:40 GMT April 19th
1 Month to 1 Year Risk Reversal
Currency 1M R/R 3M R/R 6M R/R 1 YR R/R USD/JPY 0.3/0.6 JC 0.7/1.0 JC 1.1/1.3 JC 1.3/1.6 JC EUR/USD 0.1/0.3 EC 0.0/0.3 EC 0.0/0.3 EC 0.1/0.4 EC GBP/USD 0.0/0.3 SP 0.0/0.3 SC 0.0/0.3 SC 0.0/0.3 SC USD/CHF 0.2/0.2 CC 0.0/0.3 CC 0.0/0.4 CC 0.1/0.5 CC
JC = Japanese Yen Call EC = Euro Call
SP = Sterling Put SC = Sterling Call CC = Swiss Call
Trend Look for
ADX (Average Directional Index) Greater Than 20 As mentioned earlier when we talked about range trading conditions, the Average Directional Index is one of the primary technical indicators used to determine the strength of a trend. In a trending environment, we look for ADX to be greater than 20 and rising. However, if ADX is greater then 25 but sloping downward, especially off of the extreme 40 level, you have to be careful of aggressive trend positioning since the downward slope may indicate that the trend is waning.
Momentum Consistent with Trend Direction In addition to using ADX, I also recommend looking for a confirmation of a trending environment through momentum indicators. Traders should look for momentum to be consistent with the direction of the trend. Most currency traders will look for oscillators to point strongly in the direction of the trend. For example, in an uptrend, trend traders will look for the moving averages, RSI, stochastics, and moving average convergence/divergence (MACD) to all point strongly upward. In a downtrend, they will look for these same indicators to point downward. Some currency traders use the momentum index, but only to a lesser extent. One of the strongest momentum indicators is a perfect order in moving averages. A perfect order is when the moving averages line up perfectly; that is for an uptrend, the 10-day SMA is greater than the 20-day SMA, which is greater than the 50-day SMA. The 100-day SMA and the 200-day SMA are below the shorter-term moving averages. In a downtrend, a perfect order would be when the shorter-term moving averages stack up below the longer-term moving averages.
Options (Risk Reversals) With a trending environment, we are looking for risk reversals to strongly favor calls or puts. When one side of the market is laden with interest, it is usually indicative of a strongly trending environment or that a contra- trend move may be brewing if risk reversals are at extreme levels.