What if the next SPY breakout is hiding in the forex markets?
Looking at major forex pairs like EUR/USD or USD/JPY can often lead traders to get insights into market sentiment. Forex can be a great tool for traders to gauge where the S&P 500 might be heading and get a good idea of some of the market dynamics that might be at play along the way. But it is more than just looking at the performance of the pairs themselves and zeroing in on the role of volatility within those pairs.
Rising or falling volatility in key forex pairs can offer clues about upcoming moves in SPY (S&P 500 ETF). Our guide will help you learn how to track forex volatility and translate it into actionable SPY options trades. Our hope is to help you better gauge SPY performance and spot possible breakouts by successfully reading forex volatility and analyzing the major pairs.
Why Forex Volatility Matters for SPY Traders
Traders with investments in the S&P 500 should keep a close eye on forex volatility, due to this major index having a large portion of its companies generating revenue from foreign markets. How forex pairs are performing can offer key insights into the future performance of the S&P 500. This section of the guide will go over how forex pair performance can have a big impact on SPY and how you can spot moments where forex volatility will play a crucial role in stock and asset prices on the index.
The Relationship Between SPY Performance and the US Dollar
Many traders have the idea that a strong US dollar makes for a weaker SPY performance, but the relationship between the two is a bit more complicated than that. Let’s take a closer look at how a strong or weak dollar might impact the performance of the S&P 500 Index.
Strong Dollar
- US exports can be more expensive for foreign buyers.
- A strong dollar can potentially reduce the demand and market share across the world for US multinational corporations.
- The S&P 500 is susceptible to currency fluctuations, as about 40% of revenue generated by SPY comes from international markets, so a strong dollar can create volatility within this index.
- The foreign earnings of multinational companies that are US-based are worth less when a trader converts the money back into a strong dollar. Ultimately, a strong dollar can have a significant impact on stock valuations and corporate profits.
Weak Dollar
- US exports are more competitive when the US dollar is weaker.
- Corporate earnings are boosted for companies that are a part of the S&P 500.
- Foreign earnings translate into more dollars, and this can have a positive impact on companies’ performance.
Global Risk Sentiment
Global risk sentiment often influences currency movements with the major and secondary forex pairs. As a result, traders can use the foreign exchange markets to foresee where the financial markets could be going and some of the broader shifts that could possibly be in the works. Forex markets often move first, so they can offer some signals ahead of time.
- Risk-On: Capital typically flows into higher-yielding and more volatile currencies when economic indicators are positive. Traders tend to pursue these currency pairs because they have a lot more confidence in the market direction. You’ll see these currency pairs strengthen when the market goes through this “risk-on” sentiment and can signal what’s ahead.
- Risk-Off: Also known as a “flight to safety,” risk-off sentiment is the exact opposite of risk-on, where traders are drawn to withdrawing their money from assets that carry more risk. Traders will then move their money into safe-haven currencies like the USD/JPY or USD/CHF, which will cause these forex pairs to appreciate greatly.
A few examples of risk-on currencies are the Canadian, Australian, and New Zealand dollars. These are the currencies that traders are more likely to dump when the economic indicators don’t look good, and they would transfer them into safer investments like the US dollar, Swiss franc, and Japanese yen. It is a good showcase of forex markets, being a good reflection of global political and economic sentiment. Forex pairs can often be way ahead of other markets when it comes to reacting to shifts in risk appetite from investors or traders.
Institutional Money Flows
There is a dynamic relationship between forex pairs and the equity markets. Forex can be a leading indicator of how the equity markets and institutional money flow will ultimately play out. Strong equity markets can attract foreign capital, which can lead to an increased demand for domestic currencies, which can lead to their value going up against other currencies.
Example
To give you a good idea of how traders can use forex volatility, let’s look at the currency pair of USD/JPY and the spikes that could occur when the S&P rallies or drops. The Japanese yen is considered a safe-haven currency, and you usually see investors embracing the yen when there is increased volatility in the forex markets and abandoning the risk-on investments of the S&P 500, more tied to the Canadian or Australian dollar.
When the S&P rallies, you will see investors dropping the yen in favor of the higher-yielding currencies that could produce good returns when the market outlook is positive.
Key Forex Pairs to Watch
When you’re dealing with foreign market exchange (forex), you’ll want to keep an eye on certain currency pairs for a handful of reasons, like profit potential, liquidity, and volatility. Anyone who wants to experience the best of what forex trading has to offer needs to be focused on the majors. This refers to the forex pairs that constitute the majority of daily trading volume and are the most frequently traded among investors.
- EUR/USD: This is the relationship between the eurozone and the US dollar, which is the most traded global pair. It is a good reflection of the economic sentiment between the United States and the European Union. It is well known for its tight spreads and high liquidity.
- USD/JPY: With this forex pair, there is a focus on the US dollar and the Japanese yen. It is a pair that is well-noted for its safe haven dynamics and interest rate expectations. To be clear, the pair is heavily influenced by differences in interest rates.
- GBP/USD: Now let’s look at the major forex pair of the US dollar against the British pound. It is largely impacted by events in the United Kingdom, and it’s a forex pair that is noted for its higher volatility experience. The GBP/USD can be used to signal volatility shifts.
- USD/CHF: Another safe haven pair like the USD/JPY, this forex pair is the US dollar against the Swiss franc. It is influenced greatly by the economic stability of Switzerland. It is another secondary pair that can still signal volatility shifts.
It is also worth mentioning that there are other commodity pairs like AUD/USD and USD/CAD that can also reflect a risk-on/risk-off mood. While they might not be a part of the “majors,” these secondary forex pairs can be used well in conjunction with the primary pairs to get a bigger picture of the current market condition and dynamics.
Tools to Track Forex Volatility
Forex volatility can be followed using a wide range of technical indicators and analysis tools. They can be used to assess the level of price fluctuations and potential market movements. Check out some of the tools you’ll need to successfully track forex volatility in the online markets—we haven’t included every one of them, but we have highlighted the ones that play a larger role overall.
- Average True Range (ATR) on Forex Pairs—This refers to a technical indicator that assesses how much a currency pair has moved on average. It’s also a measurement of the average price fluctuation over a certain period of time, which ultimately indicates volatility. To be clear, the ATR does not predict price direction but instead helps traders to manage their risks and to have a clearer understanding of market volatility.
- Implied Volatility Via Forex Options Markets—This tool can provide insights into the market’s expectation of future currency price fluctuations. IV can directly impact premiums for options contracts. Higher IV comes with an expectation for large price fluctuations and, therefore, results in higher premiums. Decreased premiums come as a result of lower IV. Traders need to keep in mind the factors that influence this IV, including market sentiment, option maturity, interest rate changes, option skew, and economic data releases.
- Forex Volatility Indexes—This is a tool that helps traders to assess and manage risk by discovering the degree of price fluctuations in currency pairs. A good example of one of these indices is the JP Morgan G7 FX Volatility Index. These are typically measured using indicators like ATR, Bollinger Bands, Donchian Channels, and standard deviation.
- Correlations—These refer to tools like TradingView or custom heatmaps to visualize SPY vs USD/JPY movement. You also have Bollinger Bands that can indicate potential price breakouts or consolidations. The Relative Strength Index can be used with other indicators to identify overbought or oversold conditions that are typical with increased volatility.
- Free/Paid Tools: If you’re looking for some tools that directly deal with forex volatility and gauging it effectively, check out these free or paid tools, including the following: Finviz, TradingView, and OANDA volatility data.
Interpreting the Signals
Our guide is all about the strong connection between the forex signal and the S&P 500 Index, but that connection might not always be immediately obvious on the surface. This is what makes the correct interpretation of the signals so important.
- Rising Forex Volatility: When the forex markets have increased volatility, this results in“risk-off sentiment” where traders and investors pull away from high-risk currency pairings like the Canadian, Australian, and New Zealand dollars, and they begin moving money into safe-haven currencies like the US dollar, Japanese yen, or Swiss franc. As a result of rising forex volatility, you’ll typically see a big pullback in SPY in this regard.
- Dropping Forex Volatility: On the other hand, you could have a situation where volatility in on the wane with forex pairs, which is reflective of a “risk-on environment” This could lead to a potential SPY rally where traders might move money from safe-haven currencies like the yen, franc, or US dollar and delve into currencies like the Canadian, New Zealand, and Australian dollars.
Examples of Key Divergences
It is key to note that SPY (tracking the S&P 500 index) usually has a lag in response time to the volatility signals that come from the foreign exchange market. The reason for this is due to the factors that influence each of these markets.
- Foreign Exchange Market—Forex is influenced by macroeconomic factors across the globe, as well as interest rate differentials and geopolitical events.
- SPY (S&P 500 Index)—SPY is most influenced by factors that have a significant impact on US equities, like investor sentiment toward US companies, corporate earnings releases, and economic data from the home front.
Because of the divergences between the SPY and the response time to volatility signals, traders should consider using a lead-lag analysis through signals that the forex market is giving off. Forex often moves first by 12–48 hours, and it can be a useful tool for discovering where SPY might be moving based on which currency pairs traders and investors are placing their money.
Turning Forex Volatility into SPY Options Setups
If you’re interested in some realistic and practical SPY option setups that you can use when gauging SPY volatility with the foreign exchange market, we have included several below for your convenience. We will teach you how you can take the volatility that you’re seeing in the forex markets and turn those into viable strategies for correctly trading SPY options with the best of them!
When to go Long SPY Calls After a Forex Volatility Drop
If a drop occurs in the forex volatility levels, which leads to a sustained weakening of the US dollar, it could be a good signal for getting into long SPY calls. However, there are a few things to consider, like the fact that a weakening US dollar can lead to rallies with SPY options, which focus on international companies. You should also be thinking about the fact that options contracts are more expensive when the IV of SPY is high, and choose strike prices and expiration dates that align with a bullish outlook.
When to Buy SPY Puts or Hedge When Forex Volatility Spikes
One common approach that traders will take up in this scenario is to buy SPY puts that can offer protection from the possible losses that can occur when the stock market declines as a result of higher IV in the forex markets. Traders can know with certainty that buying SPY puts to hedge is a good course of action when the market is experiencing a high level of uncertainty, with direction from other traders and investors.
Using Vertical Spreads for Directional Bets
This move is a popular go-to for traders and investors who are envisioning the SPY or forex markets moving in a certain direction. Once a bearish or bullish view has been established, the trader can choose strike prices based on the volatility expectations and their outlook. Traders who are expecting a considerable price movement in a certain currency pair can buy a debit spread on a currency option to profit from higher volatility and a directional move. On the other hand, they can sell a credit spread on currency options that can profit from the tightening of volatility and from time decay.
Using Calendar Spreads if You Expect Volatility to Expand
When traders see increased volatility in the forex markets, they can consider using a long calendar spread that can result in a profit when the volatility levels rise. To execute a successful long calendar spread, traders must buy a longer-term option and sell a shorter-term option (both need to be either calls or puts). Both must have the same strike price, and the trade makes money when there’s an increasing difference in IV between the two option contracts.
Timeframe Considerations
The choice of timeframe when it comes to using forex volatility to inform your SPY option trading strategy mostly comes down to your personal trading style, available time to commit to trading, and your overall risk tolerance.
Intraday Traders’ Timeframe
- Foreign Exchange Markets: The 1-minute to 15-minute charts are good for capturing small price fluctuations, and the 15-minute to 4-hour charts are better for day traders, allowing them to find short-term trends as well as the ideal entry or exit points for their trades.
- SPY Options: Traders can use the 1-minute to 15-minute charts for finding price movements and short-term momentum. If you’re dealing with short-term expiration options that are 7 days out or more, these can work well with SPY options as they promise the possibility for quick returns and a higher level of leverage compared to other instruments.
Swing Traders’ Timeframe
- Foreign Exchange Markets: The 4-hour charts or the daily charts are the best options for swing traders in the forex market and can be used for analyzing medium-term momentum shifts or trends. On the other hand, the weekly or monthly charts can be used to find key levels and pinpoint long-term trends.
- SPY Options: Swing traders should focus on options that are dated weeks or months out, and they can be used to take advantage of sustained price movements.
Real-World Case Studies
How has this notion of using forex pair volatility to signal SPY options moves worked out in the real-world markets? We have included a few real-world case studies that showcase the relationship and how traders can use the early signs in the foreign exchange markets to plan their next moves with their S&P 500 investments.
Historical Events That Prove Our Point
- Historically, Fed rate decisions along with a USD spike can lead to SPY reversal. US dollar-dominated investments (stock, assets, etc.) can become more attractive to traders, especially following an event where the Federal Reserve raises interest rates. The strengthening of the dollar can lead to a drop-off in SPY investments and an increased demand for the dollar against other currencies.
- Over time, there have been global crises where forex volatility spiked before the SPY crash, most notably the Asian financial crisis in the late 1990s. The crisis itself was preceded by fixed exchange rates that were US dollar-pegged and a period of rapid capital inflows. Pegged Asian currencies became less competitive as the US dollar went up in value. A currency collapse soon followed as a buildup of foreign debt occurred due to the appreciation and depreciation of each respective currency.
- Calm forex environments are typical before a strong SPY rally. A few indicators of a calm environment within the foreign exchange market include low volatility readings from the technical indicators, positive economic sentiment, and reduced tensions across the geopolitical landscape.
Forex Moves First—SPY Follows
To achieve a significant edge in SPY options trading, you should be looking at forex volatility as an early indicator of the S&P 500’s overall performance. Using forex pairings and their current performance as a gauge, you can trade SPY options and do so without being blinded to some of the market events that could be coming down to you. Watching the currency markets first can keep you ahead of other retail traders and have you approaching SPY options trading with the same stance and approach that the pros use every day!
Key Takeaways
- Forex volatility offers early clues about market risk sentiment. It is best to use it as an indicator of where SPY could be heading in the future.
- Watching just the stock market misses the full picture. Forex volatility can offer key insights into where investors are placing money (risk–on or risk-off investments), which shows either a bullish or bearish market outlook.
- Set alerts or integrate forex data into your workflow to pick up on the early indicators of where the markets may be heading.
- Try tracking USD/JPY or EUR/USD before your next SPY options play.
