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ATR and the TED Spread

Wed, Oct 1 2008, 06:30 GMT
by Online Trading Academy Team

Online Trading Academy

If you've been trading lately, you may have noticed the extraordinary volatility we've seen recently in the Forex markets. Currency volatility is at its highest point since the year 2000, as the markets swing wildly while absorbing bad news of historic proportions. The head spinning moves we've seen recently have driven the Average True Range, also known as ATR, of the major currency pairs to levels that are rarely reached.

What is Average True Range? It's a technical indicator that measures the volatility of a trading instrument, which in our case will be currency pairs. It is also used by stock and commodities traders for the same purpose. The indicator does not provide an indication of price direction or duration, but simply reveals the degree of price movement or volatility. ATR, which is typically measured over 14 periods, is normally expressed as a single line on a separate pane on the bottom of the chart. On the daily chart of EUR/USD, we can see that the ATR is giving a reading above 200 for the first time in years. This means that over the past fourteen days, EUR/USD has an average range of greater than 200 pips from high to low on any given day (see figure 1).

Figure 1: ATR on the EUR/USD daily chart shows a spike in volatility. Source: Saxo Bank

A quick look at the daily chart of GBP/USD shows a similar increase in volatility (see figure 2).

Figure 2: ATR shoots higher on the GBP/USD daily chart. Source: Saxo Bank

Why is this significant? First of all, it means that your stops and targets should be wider than normal on the affected currency pairs in response to this extraordinary volatility. If you don't adjust for the increase in volatility, your stops will be hit more easily when the price moves against you, and your profits will not be maximized when the price moves in your favor.

Another factor lurking in the shadows is the potential for central bank intervention to calm the markets. This is exactly what happened in the year 2000, and it could happen again. Intervention occurs when a central bank steps into the open market in an attempt to strengthen or weaken its own currency. The intervention in the year 2000 was a concerted effort by the Group of Seven (G7) nations to stabilize the Euro.

The wide price swings that are occurring are detrimental to trade between nations, as it becomes more difficult - and more expensive - to hedge against currency risk. For example, if you needed Yen to purchase supplies from a company in Japan, wild fluctuations in that currency would create a major headache, as it would be difficult to predict what the Yen exchange rate might be even a few days into the future. These fluctuations play havoc with businesses, which purchase futures and options contracts to protect themselves against this uncertainty. As markets become more volatile, the cost of these "insurance policies" goes higher, making life more difficult for those who depend on international trade.

Now that a huge bailout is planned for the U.S. financial sector, the fear is that massive borrowing and printing of trillions of dollars (the $700 billion price tag that is quoted in the press so often is considered by many to be overly optimistic) will be necessary to pay for this mess. This is undermining confidence in the U.S. Dollar, and helping to create the wild swings we've seen recently in the markets.

Morgan Stanley has an intervention watch index, which currently suggests an 18% chance that central bank policy makers will step into the market to influence exchange rates. Any reading above 10% suggests the risk is elevated. Right now, the index is at the same level as when the G-7 intervened in the year 2000, in an effort to prop up the Euro. Any potential joint intervention that might occur in 2008 would most likely be directed at supporting the U.S. Dollar.

Question of the Week

Q) Hi Ed, the Ted spread recently jumped to its highest level since 1987. What could be the possible reason for this and what could happen to the Ted spread in next 12 months?

Ed Ponsi) Thank you for your question; the TED spread is calculated as the gap between 3-month LIBOR (interest rate offered in the London interbank market for 3-month loans) and the 3-month Treasury bill rate. Here we can see the recent spike in the TED spread (see figure 3).

Figure 3: TED Spread shoots higher as the risk of lending to banks rises. Source: Bloomberg LP.

The 3-month Treasury is virtually risk-free (backed by the full faith and credit of the U.S. government), while lending money to banks can be hazardous to your bottom line. So, those who lend to banks deserve something in return for taking on that risk - a premium above what they would have earned by buying Treasuries. That premium is called the TED spread.

So why is the TED spread rising? Banks are not keen to lend money right now, and they are demanding a higher premium to do so. After all, so many financial institutions have fallen by the wayside recently, with new names added to the list daily, and this has severely dampened enthusiasm for lending. Where will we be 12 months from now? One would hope that the situation will improve, whether through a bailout or via economic Darwinism, but only one thing is certain - we are sailing in uncharted territory.

Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.

Published on  Wed, Oct 1 2008, 06:34 GMT