Using Tools for Predicting Foreign Exchange Rates

Traders in futures and options are familiar with concepts like implied volatility and open interest. The same tools can be used for placing profitable trades in foreign exchange markets as well.

In foreign exchange trading, implied volatility is used to measure the expected price change in a currency’s price over a given period of time. Calculation of implied volatility is based on the study of historical fluctuations and annual standard deviation of daily changes in foreign exchange rates. This is slightly different from option volatility that is a measure of the rate and extent of changes in the price of a currency. For effective prediction of future movement in the foreign exchange rates, a comparison of implied and actual volatility has to be made.

Since availability actual data is limited, a comparison of historical implied volatility (usually one-month and three-month) is considered to be a reasonably effective comparison for prediction of future of movements in currency prices. In general, implied volatility increases when the foreign exchange market is in a bearish phase and decreases in a bullish market.

Open interest, on the other hand is the total number of pending futures and options contracts or the number of buy orders before the market opens. This is different from traded volumes because open interest refers only to the number of contracts that have not been closed on a particular day. Monitoring of open interest in foreign exchange pairs at the end of each day helps in drawing conclusions of market behaviour. For example, increase in open interest indicates flow of new money in the market. Similarly, levelling of open interest after a sustained upward movement indicates the end of the upward trend.