Delta , gamma , risk reversals and volatility are concepts familiar to nearly all options traders. However, these same tools used to trade currency options can also be useful in predicting movements in the underlying, which in foreign exchange FX is the cash or spot product.

In this article, we look at how volatility can be used to determine upcoming market activity, how delta can be used to calculate the probability of spot movements, how gamma can predict trading environments and how risk reversals are applicable to the cash market.

Using Volatility to Forecast Market Activity Option volatilities measure the rate and magnitude of the changes in a currency's price. Implied option volatilities on the other hand measure the expected fluctuation of a currency's price over a given period of time based upon historical fluctuations.

Volatility calculations typically involve the historic annual standard deviation of daily price changes. Find out everything you need to know about option volatility in the Option Volatility Tutorial. Option volatility information is readily availabl from a variety of sources. In using volatility to forecast market activity, the trader needs to make certain comparisons.

Although the most reliable comparison is implied versus actual, the availability of actual data is limited. Alternatively, comparing historical implied volatilities is also effective. One-month and three-month implied volatilities are two of the most commonly benchmarked time frames used for comparison the numbers below represent percentages. Typically in range-trading scenarios, implied option volatilities are low or declining because in periods of range trading, there tends to be minimal movement.

When option volatilities take a sharp dive, it can be a good signal for an upcoming trading opportunity. This is very important for both range and breakout traders. Traders who usually sell at the top of the range and buy at bottom can use option volatilities to predict when their strategy might stop working - more specifically, if volatility contracts become very low, the likelihood of continued range trading decreases. Breakout traders, on the other hand, can also monitor option volatilities to make sure that they are not buying or selling into a false breakout.

If volatility is at average levels, the likelihood of a false breakout increases. Alternatively, if volatility is very low, the probability of a real breakout increases.

These guidelines generally work well, but traders also have to be careful. Volatilities can have long downward trends during which time volatilities can be misleading. Traders need to look for sharp movements in volatilities, not a gradual one. The green line represents short-term volatility, the red line long-term volatility and the blue line price action.

The arrows with no labels are pointing to periods when short-term volatility rose significantly above long-term volatility. You can see such divergence in volatility tends to be followed by periods of range trading. The "1M implied" arrow is pointing to a period when short-term volatility dips below long-term volatility.

At price action above that, a breakout occurs when short-term volatility reverts back toward long-term volatility. Using Delta to Calculate Spot Probabilities What Is Delta? Options price can be seen as a representation of the market's expectation of the future distribution of spot prices.

The delta of an option can be thought of roughly as the probability of the option finishing in the money. Calculating Spot Probabilities With information on deltas, one can approximate the market's expectation of the likelihood of different spot levels over time. When the probability indicates that the spot will finish above a certain level, call-option deltas are used; when the probability indicates that the spot will finish below a certain level, put-option deltas are used. The key to calculating expected spot levels is using conditional probability.

Given two events, A and B, the probability of A and B occurring is calculated as follows:. So, the probability of A and B occurring is equal to the probability of A times the probability of B given the occurrence of A.

Here is the formula applied to the problem of calculating the probability that spot will touch a certain level:. In words, the probability of spot touching and finishing above a certain level or delta is equal to the probability of spot touching that level times the probability of spot finishing above a certain level given that is has already touched that level.

Given options prices and corresponding deltas, this probability calculation can be used to get a general idea of the market's expectations of various spot levels.

The rule-of-thumb this methodology yields is that the probability of spot touching a certain level is roughly equivalent to two times the delta of an option struck at that level.

Using Gamma to Predict Trading Environments What Is Gamma? Gamma represents the change in delta for a given change in the spot rate. In trading terms, players become long gamma when they buy standard puts or calls, and short gamma when they sell them.

When commentators speak of the entire market being long or short gamma, they are usually referring to market makers in the interbank market. How Market Makers View Gamma Generally, options market makers seek to be delta neutral - that is, they want to hedge their portfolios against movement in the underlying spot rate.

The amount by which their delta, or hedge ratio , changes is known as gamma. Say a trader is long gamma, meaning he or she has bought some standard vanilla options. The net effect then is a pip profit, selling a and buying at In sum, when traders are long gamma, they are continually buying low and selling high, or vice versa, in order to hedge.

When the spot market is very volatile, traders earn a lot of profits through their hedging activity. But these profits are not free, as there is a premium to own the options. In theory, the amount you make from delta hedging should exactly offset the premium. Whether or not this is true in practice depends on the actual volatility of the spot rate. The reverse is true when a trader has sold options. When short gamma, in order to hedge, the trader must continually buy high and sell low - thus he or she loses money on the hedges, in theory the exact same amount earned in options premium through the sales.

Why Is Gamma Important for Spot Traders? But what relevance does all this have for regular spot traders? The answer is that spot movement is increasingly driven by what goes on in the options market. When the market is long gamma, market makers as a whole will be buying spot when it falls and selling spot when the exchange rate rises.

This behavior can generally keep the spot rate in a relatively tight range. When the market is short gamma, however, the spot rate can be prone to wide swings as players are either continually selling when prices fall, or buying when prices rise. A market that is short gamma will exacerbate price movement through its hedging activity.

Using Risk Reversals to Judge Market Positioning What Are Risk Reversals? Risk reversals are a representation of the market's expectations on the exchange-rate direction.

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Filtered properly, risk reversals can generate profitable overbought and oversold signals. A risk reversal consists of a pair of options, a call and a put, on the same currency, with the same expiration one month and sensitivity to the underlying spot rate. Risk reversals are quoted in terms of the difference in volatility between the two options.

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While in theory these options should have the same implied volatility, in practice they often differ in the market. A positive number indicates that calls are preferred to puts and that the market is expecting a move up in the underlying currency.

Likewise, a negative number indicates that puts are preferred to calls and that the market is expecting a move down in the underlying currency. Risk reversals can be seen as having a market polling function. A positive risk-reversal number implies that more market participants are voting for a rise in the currency than for a drop.

Thus, risk reversals can be used as a substitute for gauging positions in the FX market. How Can Risk Reversals Be Used to Predict Spot Currency Movement? While the signals generated by a risk-reversal system will not be completely accurate, they can specify when the market is bullish or bearish.

Risk reversals convey the most information when they are at relatively extreme values. These extreme values are commonly defined as one standard deviation beyond the averages of positive and negative values. Therefore, we are looking at values one standard deviation below the average of negative risk-reversal figures, and values one standard deviation above the average of positive risk-reversal figures. When risk reversals are at these extreme values, they give off contrarian signals; when the entire market is positioned for a rise in a given currency, it makes it that much harder for the currency to rally, and that much easier for it to fall on negative news or events.

A large positive risk-reversal number implies an overbought situation, while a large negative risk-reversal number implies an oversold situation. The buy or sell signals produced by risk reversals are not perfect, but they can convey additional information used to make trading decisions. Summary There are many tools used by seasoned options traders that can also be useful to trading spot FX.

Volatility can be used to forecast market activity in the cash component through comparing short-term versus longer term implied volatilities. Delta can help estimate the probability of the spot rate reaching a certain level. And gamma can predict whether spot will trade in a tighter range if it is vulnerable to wider swings.

Risk reversals are a representation of the market's expectations on exchange-rate direction. If filtered properly, risk reversals can be used to gauge market sentiment and determine overbought and oversold conditions. Dictionary Term Of The Day. A measure of what it costs an investment company to operate a mutual fund. Latest Videos PeerStreet Offers New Way to Bet on Housing New to Buying Bitcoin?

This Mistake Could Cost You Guides Stock Basics Economics Basics Options Basics Exam Prep Series 7 Exam CFA Level 1 Series 65 Exam. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. Using Options Tools To Trade Foreign-Exchange Spot By Kathy Lien Share. IFR Market News Plug-in Here is what the comparisons indicate: If short-term option volatilities are significantly lower than long-term volatilities, expect a potential breakout.

If short-term option volatilities are significantly higher than long-term volatilities, expect reversion to range trading. Given two events, A and B, the probability of A and B occurring is calculated as follows: Here is the formula applied to the problem of calculating the probability that spot will touch a certain level: Because we are interested in spot finishing above this level, we look at the EUR call option. Given current spot and volatilities, the delta of this option is By definition an at-the-money option has a delta of 50, and thus has a one-in-two chance of finishing in the money.

Here is the calculation using the above equation: When market makers are long gamma, spot generally trades in a tighter range. When market makers are short gamma, spot can be prone to wide swings. Risk reversals can generate reasonably accurate signals at extreme values Summary There are many tools used by seasoned options traders that can also be useful to trading spot FX.

Understanding price influences on options positions requires learning about delta, theta, vega and gamma. We look at the different kinds of Greeks and how they can improve your forex trading. Find the middle ground between conservative and high-risk option strategies.

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These risk-exposure measurements help traders detect how sensitive a specific trade is to price, volatility and time decay. Learn more about the position delta hedge ratio and how it can tell you the number of contracts needed to hedge a position in the underlying asset. This trading strategy will show you how to gain from a decline in implied volatility on any movement of the underlying. Discover the differences between historical and implied volatility, and how the two metrics can determine whether options sellers or buyers have the advantage.

Find out how you can use the "Greeks" to guide your options trading strategy and help balance your portfolio.

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Get Free Newsletters Newsletters. All Rights Reserved Terms Of Use Privacy Policy. IFR Market News Plug-in. Risk reversals can generate reasonably accurate signals at extreme values.