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Volatility And The Fx Market – Utilizing Volatility To Your Advantage

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by Jeff Cooper, Diane Hirschberg and Steve Santa-Maria
BMO Capital Markets Foreign Exchange

Has the recent volatility within the financial markets become the “new-norm”, or are the global financial markets working to digest the recent European Debt Crisis and return to more normal historical levels? While that question can still be the impetus for a hotly contested debate, the one item that is not debatable is that with the global markets more intertwined than ever, what happens in Greece/Europe or any other geographic region will have an impact over a wide range of markets and geographies. If 2008 disproved anything it was the notion that a crisis can be contained and only have meaningful impact in one’s home. While the equity and bond markets gather headlines with regular market moves of 2, 3 and 4% daily since mid-July, the currency markets have been weathering similar volatility moves.

The FX market segregates currencies into categories: G10 – highly liquid, freely traded currencies of developed markets that have no restrictions with regards to delivery. Emerging market or EM currencies trade less and may have restrictions on deliverability, as well as controls by its local Central Bank which can impact market values. All of these currency markets, whether developed G10 or less developed EM, are susceptible to bouts of increased volatility. EUR/USD is the largest and most liquid FX currency pair and is the best proxy for overall G10 market volatility. We have recently seen another bout of extreme volatility in the FX markets with 3 month EUR/USD implied volatilities shooting up to the 15-17% area. Since December 2008 the volatility in 3 month EUR/USD has traded as high as 24.5% vs. 9.5% just 6 months earlier. Implied volatility measures the anticipated daily moves in the underlying currency for a certain period of time in the future. To put that in perspective, the market was anticipating a move of 0.1655 points over a 3 month period in December 2008 (24.5% volatility) vs.  0.0642 points just 6 months earlier (9.5% volatility).

While extreme volatility in currency moves is painful to corporate FX and asset managers it can also create interesting and unique hedging opportunities.

Here is a compelling example of using higher levels of volatility in the options market to create a better hedge for a seller of U.S. dollars / buyer of Canadian dollars:

For the past 6 years the average volatility for 3 month at-the-money (ATM) implied USD/CAD volatility has been about 11% and has ranged from a pre-crisis low of 5.8% to a high of 25% during the 2008 financial crisis. Current 3 month USD/CAD volatility is at 12.75%.   Since the financial crisis the average 3 month implied USD/CAD volatility ratcheted up to about 13%. Not only have underlying option volatilities increased, but the difference between out-of-the-money (OTM) and ATM volatilities has also widened considerably. This difference between ATM options and lower delta options is referred to as the “skew”. The skew is the volatility difference between an ATM and an OTM option. During periods of extreme spot volatility and uncertainty, the move in the skew is a function of supply and demand for certain options, most evident through the pricing of “risk reversals” or calls vs. puts of the same delta.

Currently the options market is pricing Canadian dollar puts at higher volatilities than Canadian dollar calls. Since 2005 the average skew for 25 delta options has been roughly 0.5%, currently this skew is 4% (favoring CAD puts).

The combination of high implied volatility and the pronounced bid for CAD puts vs. CAD calls presents some appealing hedge opportunities for USD sellers.

Collars (zero cost) are a popular hedging strategy and the high risk reversal creates an opportunity to construct collars that take advantage of this factor. For example, with spot at 1.0300, the 3 month forward at 1.0320 and the 3 month vol at 12.7, a collar protecting 1.0000 would have a corresponding CAD put of 1.0660 with no skew priced in. This would be almost symmetrical around the forward; 0.0320 point give up vs. the forward compared to a 0.0344 point benefit. However, by taking advantage of the elevated demand for CAD puts, which the hedger is selling, the collar would come in at 1.0000 – 1.0809. The benefit level has increased to 0.0489 points, giving the collar a 0.0169 advantage over the collar with no skew. To the hedger, the fact that the market is “bidding up” the risk reversal has no bearing on the protection level but does present an opportunity to take advantage and gain a desirable hedge position.

Hedgers may also be able to positively utilize extreme levels of volatility when constructing a hedge by selling the volatility and having that “short-volatility” position embedded into their hedge. The hedge will have clearly defined points of protection and participation but by selling the volatility at historically high levels, the value of that volatility can be used to tilt the symmetrical nature of the hedge in the hedger’s favor. For example: a variation on the collar modeled after a Forward Extra trade can be used to gain much of the advantage of the collar in addition to selling the high volatility. The hedger can buy the same 3 month 1.0000 protection (CAD call) and sell a 1.0600 CAD put that only knocks in if spot USD/CAD trades at 1.1600 at any time during the life of the option (zero cost). The hedger has not only taken advantage of the high skew but also the high level of volatility. If volatility and the risk reversal had been closer to historical norms of 11% and 0.5% for CAD puts respectively, the barrier would be 1.0900 in order to enter the hedge at zero cost. This hedge allows the hedger a best case rate of 1.1599, a benefit of 0.1279 points over the forward, while only ‘costing’ 0.0209 points of give up over the regular collar.

Many times volatility and skew can be important factors in implementing attractive hedges, and can, as the above strategies illustrate, give hedgers a significantly more advantageous risk/reward scenario. Savvy hedgers should be asking their FX banks for ideas that incorporate these advantages. ~

To learn how BMO Capital Markets can help you achieve your ambitions, email us at [email protected], or visit www.bmocm.com/fx for a list of contacts in your area.

Disclaimer: The information, opinions, estimates, projections and other materials contained herein are provided as of the date hereof and are subject to change without notice. Some of the information, opinions, estimates, projections and other materials contained herein have been obtained from numerous sources and Bank of Montreal (“BMO”) and its affiliates make every effort to ensure that the contents thereof have been compiled or derived from sources believed to be reliable and to contain information and opinions which are accurate and complete. However, neither BMO nor its affiliates have independently verified or make any representation or warranty, express or implied, in respect thereof, take no responsibility for any errors and omissions which may be contained herein or accept any liability whatsoever for any loss arising from any use of or reliance on the information, opinions, estimates, projections and other materials contained herein whether relied upon by the recipient or user or any other third party (including, without limitation, any customer of the recipient or user). Information may be available to BMO and/or its affiliates that is not reflected herein. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice or as a recommendation to enter into any transaction. Additional information is available by contacting BMO or its relevant affiliate directly. BMO and/or its affiliates may make a market or deal as principal in the products (including, without limitation, any commodities, securities or other financial instruments) referenced herein. BMO, its affiliates, and/or their respective shareholders, directors, officers and/or employees may from time to time have long or short positions in any such products (including, without limitation, commodities, securities or other financial instruments). BMO Nesbitt Burns Inc. and/or BMO Capital Markets Corp., subsidiaries of BMO, may act as financial advisor and/or underwriter for certain of the corporations mentioned herein and may receive remuneration for same. BMO Capital Markets is a trade name used by BMO Financial Group for the wholesale banking businesses of Bank of Montreal, BMO Harris Bank N.A. and Bank of Montreal Ireland p.l.c., and the institutional broker dealer businesses of BMO Capital Markets Corp., BMO Nesbitt Burns Trading Corp. S.A., BMO Nesbitt Burns Securities Limited and BMO Capital Markets GKST Inc. in the U.S., BMO Nesbitt Burns Inc. in Canada, Europe and Asia, BMO Nesbitt Burns Ltée/Ltd. in Canada, BMO Capital Markets Limited in Europe, Asia and Australia and BMO Advisors Private Limited in India.
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Factors That Affect the Direction of the Stock Market

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Factors That Affect the Direction of the Stock Market 1

A stock price represents the value of a particular stock of a particular entity, asset or another financial instrument. It is calculated by calculating the price per share of the stock at a particular price and period in time.

There are various factors that affect the direction of the stock market. These factors include interest rates and inflation rates as well as the state of the economy. If one of these factors is not in the favor of the stock market, then it could bring about a downfall of its value.

The stock prices are also affected by various stock indexes, which provide information on a particular company or industry. It helps to analyze the trends of the stock market and makes better decisions when buying and selling.

However, there are some major factors that can influence the performance of the stock market. One such factor is the state of the economy. The state of the economy refers to how well the economy is doing economically. If there is an economic decline in a particular country, then the state of the economy would be affected and the stock market would also take a hit.

Economic conditions can also affect the performance of the stock markets. For example, if the state of the economy is poor and the population is experiencing unemployment, then the economy will suffer and the stock prices will definitely take a hit.

Political turmoil can also bring about a negative effect on the stock markets because it affects the economic conditions and the way people relate to the government. When there is a lack of confidence in the state of the economy and people tend to sell off their stock at cheaper prices, the stocks of the company would suffer.

Another important factor that influences the direction of the stock market is the change in the global economy. It has been proven that the changes in the global economy are very large and it can affect the direction of the stock market in a major way. For example, during the global recession in 2020, the stock prices of many companies suffered a great deal and so did the profits of the company.

The most important thing that determines the direction of the stock market is the state of the economy and the state of the country in which the stock market is based. It is therefore, very important to invest in the stock market as a company that is in good condition. This is because it will help in ensuring the stability in the economy.

The price of the stock market is also affected by the political stability of the country in which the stock market is based. If there is a rise in the political instability, then the price of the stocks would surely go up. However, when the political stability improves, the prices of the stocks will definitely fall.

The factors that affect the direction of the stock market include the conditions in which the economy is doing. It is therefore, very important to have a good understanding of how the economic conditions in a certain country are progressing. This will help in making better investments.

There are certain countries that are very stable and these countries have a very high demand for the stocks of other countries. This means that people from those countries will invest in stocks of countries that are in good condition, and these investments will yield profits for them.

There are also certain countries that have very bad economic conditions and these countries have a very low demand for the stocks of other countries. These countries are also in need of investments and these investments will yield huge losses for them. Therefore, investing in these countries is not advised because these stocks will yield zero returns.

The stock markets are not stable unless there are good economic conditions prevailing in a country. This means that one has to know the economic condition of the country in order to make investments. Investing in the stock market is the best way to do this because investing will always yield returns, as long as the country in which one is investing is stable.

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How has the online trading landscape changed in 2020?

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How has the online trading landscape changed in 2020? 2

By Dáire Ferguson, CEO, AvaTrade 

This year has been all about change following the outbreak of coronavirus and the subsequent global economic downturn which has impacted nearly every aspect of personal and business life. The online trading world has been no exception to this change as volatility in the financial markets has soared.

Although the global markets have been on a rollercoaster for some time with various geopolitical tensions, the market swings that we have witnessed since March have undoubtedly been unlike anything seen before. While these are indeed challenging times, for the online trading community, the increased volatility has proven tempting for those looking to profit handsomely.

However, with the opportunity to make greater profits also comes the possibility to make a loss, so how has 2020 changed the online trading landscape and how can retail investors stay safe?

Lockdown boost

Interest rates offered by banks and other traditional forms of consumer investments have been uninspiring for some time, but with the current economic frailty, the Bank of England cut interest rates to an all-time low. This has left many people in search of more exciting and rewarding ways to grow their savings which is indeed something online trading can provide.

When the pandemic hit earlier this year, it was widely reported that user numbers for online trading rocketed due to disappointing savings rates but also because the enforced lockdown gave more people the time to learn a new skill and educate themselves on online trading.

Dáire Ferguson

Dáire Ferguson

A volatile market certainly offers great scope for profit and new sources of revenue for those that are savvy enough to put their convictions to the test. However, where people stand the chance to profit greatly from market volatility, there is also the possibility to make a loss, particularly for those that are new to online trading or who are still developing their understanding of the market.

The sharp rise in online trading over lockdown paired with this year’s unpredictable global economy has led to some financial losses, but with a number of risk management tools now available this does not necessarily have to be the case.

Protect your assets

Although not yet widely available across the retail market, risk management tools are slowly becoming more prevalent and being offered by online traders as an extra layer of security for those seeking to trade in riskier climates.

There are a range of options available for traders, but amongst the common tools are “take profit” orders in conjunction with “stop loss” orders. A take profit order is a type of limit order that specifies the exact price for traders to close out an open position for a profit, and if the price of the security does not reach the limit price, the take profit order will not be fulfilled. A stop loss order can limit the trader’s loss on a security position by buying or selling a stock when it reaches a certain price.

Take profit and stop loss orders are good for mitigating risk, but for those that are new to the game or who would prefer extra support, there are even some risk management tools, such as AvaProtect, that provide total protection against loss for a defined period. This means that if the market moves in the wrong direction than originally anticipated, traders can recoup their losses, minus the cost of taking out the protection.

Not a day has gone by this year without the news prompting a change in the financial markets. Until a cure for the coronavirus is discovered, we are unlikely to return to ‘normal’ and the global markets will continue to remain highly volatile. In addition, later this year we will witness one of the most critical US presidential elections in history and the UK’s transition period for Brexit will come to an end. The outcome of these events may well trigger further volatility.

Of course, this may also encourage more people to dip their toes into online trading for a chance to profit. As more people take an interest and sign up to online trading platforms, providers will certainly look to increase or improve the risk management tools on offer to try and keep new users on board, and this could spell a new era for the online trading world.

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Trading Strategies

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Trading Strategies 3

By Paddy Osborn, Academic Dean, London Academy of Trading

Whether you’re negotiating a business deal, playing a sport or trading financial markets, it’s vital that you have a plan. Top golfers will have a strategy to get around the course in the fewest number of shots possible, and without this plan, their score will undoubtedly be worse. It’s the same with trading. You can’t just open a trading account and trade off hunches and hopes. You need to create a structured and robust plan of attack. This will not only improve your profitability, but will also significantly reduce your stress levels during the decision-making process.

In my opinion, there are four stages to any trading strategy.

S – Set-up

T – Trigger

E – Execution

M – Management

Good trading performance STEMs from a structured trading process, so you should have one or more specific rules for each stage of this process.

Before executing any trades, you need to decide on your criteria for making your trading decisions. Should you base your trades off fundamental analysis, or maybe political news or macroeconomic data? If so, then you need to understand these subjects and how markets react to specific news events.

Alternatively, of course, there’s technical analysis, whereby you base your decisions off charts and previous price action, but again, you need a set of specific rules to enable you to trade with a consistent strategy. Many traders combine both fundamental and technical analysis to initiate their positions, which, I believe, has merit.

Set-up

What needs to happen for you to say “Ah, this looks interesting! Here’s a potential trade.”? It may be a news event, a major macro data announcement (such as interest rates, employment data or inflation), or a chart level breakout. The key ingredient throughout is to fix specific and measurable rules (not rough guidelines that can be over-ridden on a whim with an emotional decision). For me, I may take a view on the potential direction of an asset (i.e. whether to be long or short) through fundamental analysis, but the actual execution of the trade is always technical, based off a very specific set of rules.

To take a simple example, let’s assume an asset has been trending higher, but has stopped at a certain price, let’s say 150. The chart is telling us that, although buyers are in long-term control, sellers are dominant at 150, willing to sell each time the price touches this level. However, the uptrend may still be in place, since each time the price pulls back from the 150 level, the selling is weaker and the price makes a higher short-term low. This clearly suggests that upward pressure remains, and there’s potential to profit from the uptrend if the price breaks higher.

Trigger

Once you’ve found a potential new trade set-up, the next step is to decide when to pull the trigger on the trade. However, there are two steps to this process… finger on trigger, then pull the trigger to execute.

Paddy Osborn

Paddy Osborn

Continuing the example above, the trigger would be to buy if the price breaks above the resistance level at 150. This would indicate that the sellers at 150 have been exhausted, and the buyers have re-established control of the uptrend.  Also, it is often the case that after pause in a trend such as this, the pent-up buying returns and the price surges higher. So the trigger for this trade is a breakout above 150.

Execution

We have a finger on the trigger, but now we need to decide when to squeeze it. What if the price touches 150.10 for 10 seconds only? Has our resistance level broken sufficiently to execute the trade? I’d say not, so you need to set rules to define exactly how far the price needs to break above 150 – or for how long it needs to stay above 150 – for you to execute the trade. You’re basically looking for sufficient evidence that the uptrend is continuing. Of course, the higher the price goes (or the longer it stays above 150), the more confident you can be that the breakout is valid, but the higher price you will need to pay. There’s no perfect solution to this decision, and it depends on many things, such as the amount of other supporting evidence that you have, your levels of aggression, and so on. The critical point here is to fix a set of specific rules and stick to those rules every time.

Management

Good trade management can save a bad trade, while poor trade management can turn an excellent trade entry into a loser. I could talk for days about in-trade management, since there are many different methods you can use, but the essential ingredient for every trade is a stop loss. This is an order to exit your position for a loss if the market doesn’t perform as expected. By setting a stop loss, you can fix your maximum risk on a trade, which is essential to preserving your capital and managing your overall risk limits. Some traders set their stop loss and target levels and let the trade run to its conclusion, while others manage their trades more actively, trailing stop losses, taking interim profits, or even adding to winning positions. No matter how you decide to manage each trade, it must be the same every time, following a structured and robust process.

Review

The final step in the process is to review every trade to see if you can learn anything, particularly from your losing trades. Are you sticking to your trading rules? Could you have done better? Should you have done the trade in the first place? Only by doing these reviews will you discover any patterns of errors in your trading, and hence be able to put them right. In this way, it’s possible to monitor the success of your strategy. If your trades are random and emotional, with lots of manual intervention, then there’s no fixed process for you to review. You also need to be honest with yourself, and face up to your bad decisions in order to learn from them.

In this way, using a structured and robust trading strategy, you’ll be able to develop your trading skills – and your profits – without the stress of a more random approach.

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