Forex Volatility Surges. Why? And What Might we do Next?

• Forex volatility risks surge on sudden market panic
• Our focus shifts towards our volatility-friendly strategies
• Keep an eye on stocks and 'risk' for next clues on price action

The US Dollar tumbled and the Japanese Yen surged as global stock markets sold off sharply. What happened? And more importantly, what might we expect next?

Markets entered a veritable panic as we saw the Shanghai Composite post a remarkable 8.5 percent at the Sunday open, and contagion gripped broader markets as the US Dow Jones Industrial Average lost over 6 percent to start Monday trading. The effects in global currencies was similarly swift: the US Dollar entered a veritable free-fall versus the Japanese Yen as the USD/JPY shed a remarkable 300+ pips in under 15 minutes.

Why?

Markets ostensibly fell because of the initial panic in Chinese markets, but a simpler explanation is to claim that fear gripped a broad swath of traders in what is typically supposed to be a quiet period for financial markets. To that end we attempt to measure the likelihood that such fear-driven moves will continue.

FX derivatives markets predict that the coming week will see the largest currency moves since early June—hardly a major warning of turmoil ahead. It is perhaps a reminder that a three-day stretch market panic won’t necessarily translate into an extended sell-off. Yet it will be important to trade defensively until we see meaningful signs of normal market conditions.

Forex Volatility Prices Surge on Sudden Market Panic, Point to Bigger Moves Ahead

Data source: Bloomberg, DailyFX Calculations

A study of retail trader performance shows that most tend to do poorly during times of high volatility. Why exactly? Put simply, most retail traders tend to range trade—buy when prices are low and sell when prices are high. And indeed we might expect such a strategy will underperform if markets are seeing major price extension in one direction.

Traders should likely avoid range trading until we see some semblance of ‘normalcy’ in currency trading markets. In the meantime we’ll look to our volatility-friendly Breakout2 to outperform across key US Dollar and Japanese Yen pairs.

Options-based volatility prices are historically the best predictors of actual market moves. Obviously no indicator is perfect, but given elevated levels we would expect the recent episode of market swings to continue.