Expectations are the forces that drive financial markets. Investors build their positions and strategies based on expectations, projections and views. For anyone who wants to know what the general consensus of the market, finding would have been extremely difficult in the absence of financial instruments, such as derivatives.
Current asset price reflects the momentary equilibrium (i.e., the price where the supply meets the demand and vice versa). However, if we want to know the expectations with regards to the medium/long-term future, we need to turn to the derivatives market.
The derivatives market is used by different market participants to express views (or to hedge) future exposures (as discussed in our last article “Not What You Have Been Taught: Why Capital Market is Not a Zero Sum Game”). For that reason, if one wants to assess the general consensus regarding a certain asset, in most cases the answer will be found in the price.
The derivatives market can be divided into three main instrument types:
1. Futures/Forwards – the Futures/Forwards reflect the future price of assets, taking into account the cost of carry (interest rate differentials/dividends/storage costs for commodities)
2. Swaps – Mostly used for interest rate yield curve. Reflects the market expectations regarding the monetary policy (rate hike probability), inflation path and credit risk (the risk of companies’ default)
3. Options – Options’ prices reflect both the expected volatility of the underlying asset and the spot distribution density for the specific maturity (for example 3-month time)
In our view, Options are, by far, the most interesting instruments for analysis of the market expectations, as they are widely available for the liquid assets and provide a reliable gauge.
Let’s review the following example:
GBP/USD Spot = 1.33
3-month implied volatility = 10%
As we can see in the chart above, the market expectation, based on the option market pricing, is that the GBP/USD will stay within the 1.3030-1.3630 range for the next 3-months (that range equals to 1 standard deviation around the current forward price).
Once the market participants digest new development, that expectation can change and is subjected to the supply/demand of the different participants. Some investors might look to hedge themselves of the large move of the GBP/USD (or to speculate that it will move), and therefore will go and buy options to express that view. The demand for options will cause the options price to rise, and therefore imply a wider distribution density. If investors think that the upcoming period is going to exhibit low volatility (i.e. calmer price action), they will express their view by selling options, and therefore the implied distribution will become narrower.
As we can see, there is ongoing feedback between the market expectations and the derivatives prices. This is why the derivatives market is where analysts, investors and policy makers would be able to read into the market expectations. Even though policy makers (Central Bankers) will not relay their decision on the market expectations (meaning that they will not try to meet the market expectation), they use it to assess their communication with the market (and to assess how their forward guidance is perceived by investors).
How to capitalize the knowledge of the implied market expectations:
1. Once we establish our views (or expectations), we can analyze whether our views meet the market expectations
2. If our views deviate significantly from the market expectations, we can use derivatives (options, futures) to leverage our views and put a position which expresses our views for a relatively cheap price (as our views are perceived as views that have a low probability of ending “in-the-money”)
3. We should try and “leg in” into a position and not allocate our full investment all at once. As we usually place contrarian positions to what the market expects, it is possible that the divergence between our view and the market’s view can grow further before it reverts
1. Introduction This risk disclosure and warning notice is provided to you (our Client and prospective Client) in compliance to the Provision of Investment Services, the Exercise of Investment Activities, the Operation of Regulated Markets and Other Related Matters Law 144(I)/2007, as subsequently amended from time to time (“the Law”), which is applicable in WGM Services Limited (“the Company”). All Clients and prospective Clients should read carefully the following risk disclosure and warnings contained in this document, before applying to the Company for a trading account and before they begin to trade with the Company. However, it is noted that this document cannot and does not disclose or explain all of the risks and other significant aspects involved in dealing in Binary Options. The notice was designed to explain in general terms the nature of the risks involved when dealing in Binary Options on a fair and non-misleading basis.
2. Risks 2.1. Trading in Binary Options is VERY SPECULATIVE AND HIGHLY RISKY and is not suitable for all members of the general public but only for those investors who: (a) understand and are willing to assume the economic, legal and other risks involved. (b) taking into account their personal financial circumstances, financial resources, life style and obligations are financially able to assume the loss of their entire investment. (c) have the knowledge to understand Binary Options trading and the underlying assets and markets. 2.2. The Company will not provide the Client with any advice relating to Binary Options, the underlying assets and markets or make investment recommendations of any kind. So, if the Client does not understand the risks involved he should seek advice and consultation from an independent financial advisor. If the Client still does not understand the risks involved in trading in Binary Options, he should not trade at all. 2.3. Binary Option are derivative financial instruments deriving their value from the prices of the underlying assets/markets in which they refer to (for example currency, equity indices, stocks, metals, indices futures, forwards etc.). Although the prices at which the Company trades are set by an algorithm developed by the Company, the prices are derived from the underlying assets /market. It is important therefore that the Client understands the risks associated with trading in the relevant underlying asset/ market because fluctuations in the price of the underlying asset/ market will affect the profitability of his trade.