The main impact of COVID-19 on forex trading has been volatility. The FOREX markets in March have been more volatile than any time in the past five years. Using a measurement of both historical volatility and historical implied volatility you can see that fear has created whipsaw price action that has continued into April. There continues to be fear that COVID-19 will perpetuate and will not allow traders to determine what the fundamentals will be like when the world attempts to go back to normal.
What is Volatility?
One of the best ways to measure the whipsaw price action that is experienced in the forex market is historical volatility. This technique looks at the daily (weekly, or monthly) returns, and then calculates a standard deviation. This is the variance in the exchange rate relative to the historical average. The standard deviations are then multiplied by the square root of time, which provides a calculation called historical volatility. The historical volatility calculation tells you the extent of volatility when you look back in time.
What is Implied Volatility and What is it Used For?
Another calculation that you can use to determine how volatile the markets will be in the future is implied volatility. This calculation is used in option pricing by options traders to define how volatile a currency pair will be at some point in the future. The difference between implied volatility and historical volatility is that one is forward-looking (implied volatility) while the other is historical (what has already occurred). You can also chart both measures to see how volatile the currency markets have been.
According to the Chicago Board of Options Exchange, the Euro currency VIX measures the market’s expectation of 30-day implied volatility of the $US/Euro exchange rate. The method used is the same method the CBOE uses to calculate the VIX on the S&P 500 index. During March, the CBOE EVZ climbed to 20% the largest its been since 2015. This was up from the 6% reading that occurred in mid-February. While the EVZ has eased since hitting a high of 20%, it is still more than double in early April relative to its reading in mid-February. Not only is the EVZ used to help determine the future movements of the EUR/USD currency pair, it is also an input that is used to price options. Implied volatility is the key input to help determine the likelihood that the exchange rate of the EUR/USD will be at a specific level at some point in the future.
During March the EUR/USD experienced a wild ride. Initially, the currency pair surged and then tumbled and then rebounded only to sell-off. This tells you that the market is unsure of the next direction, and any direction can be a wild swing. Traders are very quick to abandon positions as they are unsure of the next move.
The Bottom Line
The upshot is that COVID-19 has created significant volatility in the currency markets. The exchange rate versus the dollar has seen multiple 2% moves each week over the past 6-weeks. The uncertainty of the fundamentals is creating volatility as traders are unsure of how COVID-19 will impact the global economy when the spread of the virus is finally contained. Traders appear to be unwilling to hold on to positions for extended periods as the whipsaw price action is creating uncertainty. Until market participants have a better handle on how the future will play out, the currency markets will likely remain volatile.
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Chris Graham
