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Australian Dollar Volatility and Sentiment Warns of Major Top – When?

By , Quantitative Strategist
07 August 2012 15:10 GMT

Australian Dollar/US Dollar options show that 3-month volatility expectations have fallen below the 10% mark for only the third time since 2008, and directional sentiment on those same AUDUSD derivatives warns that traders are at their most relatively bullish since the pair traded towards record-peaks through 2011.

Recent CFTC Commitment of Traders data shows similar dynamics in speculative futures positioning, and finally our proprietary retail trader-based measures show AUDUSD sentiment at levels that have coincided with short-term tops. Timing turnarounds is extremely difficult, but we’ll watch forex volatility and sentiment to confirm a trend change.

Forex Correlations Summary

View forex correlations to the Dow Jones Industrial Average, Crude Oil Futures prices, US S&P 500 Volatility Index, UK FTSE 100, and Spot Gold prices.

Dow Jones

EURUSD

GBPUSD

USDJPY

AUDUSD

USDCAD

NZDUSD

USDOLLAR

1 Week

0.87

0.70

0.44

0.85

-0.93

0.82

-0.77

1 Month

0.75

0.75

0.32

0.77

-0.86

0.79

-0.81

3 Month

0.61

0.68

0.28

0.79

-0.86

0.76

-0.71

1 Year

0.67

0.59

0.00

0.82

-0.83

0.79

-0.72

Crude Oil

EURUSD

GBPUSD

USDJPY

AUDUSD

USDCAD

NZDUSD

USDOLLAR

1 Week

0.69

0.51

0.58

0.68

-0.83

0.69

-0.56

1 Month

0.55

0.52

0.28

0.60

-0.66

0.56

-0.60

3 Month

0.61

0.58

0.20

0.68

-0.79

0.61

-0.67

1 Year

0.42

0.37

0.11

0.58

-0.56

0.50

-0.49

S&P VIX

EURUSD

GBPUSD

USDJPY

AUDUSD

USDCAD

NZDUSD

USDOLLAR

1 Week

-0.48

-0.57

-0.18

-0.70

0.55

-0.87

0.56

1 Month

-0.64

-0.66

-0.39

-0.79

0.77

-0.85

0.73

3 Month

-0.52

-0.58

-0.37

-0.78

0.73

-0.74

0.61

1 Year

-0.61

-0.51

-0.02

-0.73

0.71

-0.71

0.65

FTSE100

EURUSD

GBPUSD

USDJPY

AUDUSD

USDCAD

NZDUSD

USDOLLAR

1 Week

0.46

0.22

0.69

0.44

-0.60

0.52

-0.28

1 Month

0.45

0.52

0.31

0.66

-0.62

0.72

-0.57

3 Month

0.39

0.44

0.41

0.58

-0.57

0.57

-0.41

1 Year

0.48

0.41

0.07

0.70

-0.66

0.67

-0.57

Gold

EURUSD

GBPUSD

USDJPY

AUDUSD

USDCAD

NZDUSD

USDOLLAR

1 Week

0.84

0.82

0.07

0.82

-0.95

0.70

-0.86

1 Month

0.62

0.57

0.18

0.59

-0.69

0.57

-0.65

3 Month

0.57

0.31

-0.26

0.41

-0.30

0.42

-0.57

1 Year

0.28

0.22

-0.21

0.31

-0.22

0.29

-0.36

Perfect Positive Correlation:

1.00

Perfect Negative Correlation:

-1.00

Correlation between Australian Dollar/US Dollar Exchange Rate and 3M Implied Volatility

australian_dollar_forecast_top_but_when_body_AUDchart1.png, Australian Dollar Volatility and Sentiment Warns of Major Top – When?

Australian Dollar/US Dollar Exchange Rate (lhs)

Australian Dollar/US Dollar 3-Month Implied Volatility (rhs)

Correlation between AUDUSD and 3-Month implied Volatility

The correlation between the Australian Dollar and AUDUSD Options 3-month Implied Volatility trades near its most negative levels on record, and extremely low volatility warns of a potential Aussie turnaround. We’ve previously highlighted the very negative correlation between the AUDUSD and the US S&P 500 Volatility Index (VIX).

Implied volatility on 3-month Australian Dollar options now trades below the psychologically significant 10% mark for only the third time since 2008, and previous instances have coincided with important AUDUSD tops. Why that might be the case?

The Australian Dollar continues to benefit from speculative flows as it boasts the highest interest rates of any G10 currency. According to overnight London Interbank Offered Rates (LIBOR), the AUD offers a substantial 3.5% yield advantage over the US Dollar. Such a differential helps explain why the CFTC Commitment of Traders report shows speculative futures traders are their most net-long AUDUSD since early May. FX Options risk reversals also show options traders are near their most relatively bullish since the pair traded towards record peaks through Q2, 2011.

On the face of it, the sharply negative correlation between the AUDUSD and volatility points to further Australian Dollar gains. Yet the risk of reversal is especially high given the clear levels of complacency across FX options markets.

Our proprietary retail forex trader-based Speculative Sentiment Index data likewise warns that the Australian Dollar is likely near a significant top.

Retail Forex Trading Crowds Most Net-Short AUDUSD Since July Top

australian_dollar_forecast_top_but_when_body_AUDchart2.png, Australian Dollar Volatility and Sentiment Warns of Major Top – When?

If SSI ratio (rhs) is negative, it represents the number of traders short for every one long. If it is positive, it is the number of traders long per every short. For a full explanation of the SSI, see our FXCM Expo presentation.

According to FXCM execution desk data, there are nearly 3 retail traders short AUDUSD for every one that is long. We would most often take a contrarian view of retail trading crowd sentiment; if most traders are short, we prefer going long. Yet an AUDUSD SSI ratio of -3.0 has coincided with several significant tops dating back to mid-2011.

Volatility Levels and Extreme Forex Sentiment Warn of AUDUSD Top – But When?

Forex correlations with volatility, one-sided speculative futures and options positioning, and extreme retail crowd trading sentiment warn of a significant Australian Dollar top. Yet timing major turnarounds is extremely difficult, and in fact our own SSI-based trading strategies most recently went long AUDUSD. How then might we attempt to trade the reversal?

If we see substantial capitulation from retail FX traders and a shift towards buying, our SSI-based “Tidal Shift” strategy would likely go short the AUDUSD. As the name implies, said system looks to catch a major shift in the so-called tide (trend). Past performance is not indicative of future results, but we’ll keep a close eye on the SSI and the “Tidal Shift” system as it has historically caught important tops/bottoms across major currency pairs.

Given clear risk of AUDUSD reversal, such a trade in our opinion offers strong risk/reward and we’ll look to trade accordingly.

--- Written by David Rodriguez, Quantitative Strategist for DailyFX.comTo contact David, e-mail drodriguez@dailyfx.comTo be added to David’s e-mail distribution list for this and other reports, e-mail subject line “Distribution List” to drodriguez@dailyfx.com

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07 August 2012 15:10 GMT