The FX Options Market's Take On The EUR-USD

| About: CurrencyShares Euro (FXE)

An old professor of mine at the National University of Singapore mentioned that he had read a research paper that concluded that the options market is an excellent leading indicator of events to come. This is due to options being traded by "sophisticated" investors who disseminate information more efficiently.

Regardless of options being leading indicators or not, there is a lot of information contained in option pricing and its trends over time. In the FX options market, there are two indicators watched closely on the trading floor, those being the 1 Month 25 Delta Risk Reversals and the 1 Month ATM (at the money) Implied Volatility.

Although both these indicators sound intimidating, you can understand the information being conveyed in each without knowing how to mathematically prove them.

The 1M ATM Implied Volatility (EUR-USDV1M), based on the Black Scholes option pricing model, is a measure of the market expected future volatility of a currency exchange rate from now until the maturity date. An easier way to think of it is demand; the higher the demand for an option, the higher the implied volatility.

The 1M 25 Delta Risk Reversals (EUR-USD25R1M) is a measure of the skew in the demand for out of the money options at high strikes compared to low strikes and can be interpreted as the market view of the most likely direction of the spot movement over the next maturity date. All the retail investor is required to know is that it is the demand of an out of the money call minus the demand of an out of the money put. Therefore, if the 1M 25 Delta Risk Reversal is positive, calls are in more demand than puts and the option market anticipates the currency will rise. Likewise, if the 1M 25 Delta Risk Reversal is negative, puts are in more demand than calls and the option market anticipates the currency will rise.

Below are two charts. The first is the EUR-USD charted over the last month with the white line indicating the EUR-USD, the yellow line indicating the EUR-USDV1M and the green line indicating the EUR-USD25R1M. The second chart uses the same colors, but is for the past 5 years.

On the 1 month chart, the price of calls relative to puts has returned to the level it was at the beginning of the month. What is interesting is that the price of calls leading up to today's has been trending down, indicating puts becoming more valuable than calls over this week and since the details of the sterilized bond purchases had been "leaked". This coincided with a pickup in implied volatility leading up to this meeting, meaning that option activity has picked up.

The 5 year chart provides greater perspective on where the EURUSD options are priced. It turns out that calls are at close to 2 year highs relative to puts, meaning that there has been a wave of option buying since the end of 2011. The "sophisticated" investors see the EURUSD continuing to rise. Option buying has been inverse to the EURUSD price action, and there was even a time when calls were more expensive than puts back in 2008. Interestingly, the option market does appear to be a leading indicator, with the prices of calls relative to puts reacting much quicker than the underlying EURUSD price action. There may be some truth in the paper my professor was speaking of after all.

Implied volatility is at 5 year lows, a topic of much discussion. If history is any guide, this will not last.

Ahead of Draghi's ECB announcement, the option market has seen the demand for calls soften relative to puts over the last month, indicating that the option market has seen its optimism fade for the EURUSD. But put in a larger context, the option market is at a 2 year high with demand for calls relative to puts, indicating that the EURUSD rally as of late may still have legs over the longer term. After Draghi's disappointing ramble after the "whatever it takes" rhetoric, it'll be interesting to see if he steps up to the plate this time and delivers.

Disclosure: I am short FXE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.