Market Breadth Primer: Forex Majors And Their Surprising Correlations With Historical Volatility

By Lawrence

Display of Waveforms Traders often talk about volatility. Many brokerages even offer volatility reports on various timeframes across all the forex pairs as a service to their clients. People talk about volatility because they think that if they know something about the volatility they can find better trading opportunities when the volatility picks up. They also like to improve their money management with better control of their stops so that they will not be stopped out of their positions prematurely.

But is that all you can do with volatility measures?

Are they missing something important?

Here is a completely different take on the subject.

 

Forex Majors Are Affected By Its Derivatives More Than You Think

Due to the strong liquidity of the forex majors, their OTC options, swaps and other derivatives are very actively traded too. These secondary markets do not just trade off the price of the majors. Instead, they dictate the important directional moves in the majors behind the scene.

People often assume that the forex markets are so liquid that it is not possible for any single party to control the price movement in these markets for long. The truth is far more surreal. All major market making activities on forex derivatives are conducted by the same small group of institutions all over the world while their hedging models (or algorithms if you prefer the term) are all similar to each other. Hence, their aggregated approach in hedging these derivative products created a force that is many times stronger than all the other players combined.

So, it is not a single entity that control the behaviour of the currencies. Instead, it is a group of entities that somehow thinking alike acted upon on the currencies based on their models that all telling them the same damn thing. In the eyes of a third party observer, the aggregated result is no different from the market having a mind of its own that loves to mess with the small traders.

These constant position adjustments to the forex derivatives affects the way the forex majors move structurally around various round number levels. The hedging actions of these derivatives sometimes dampen and sometimes exaggerate the underlying forex markets. Since many of these derivatives are volatility driven, they cause skewered behaviour in both the volatility and the forex market price movements.

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