The put/call ratio is a tool gauging how the market feels about a currency. The ratio is derived by dividing the number of recently traded put options by the number of recent call options. The result is a fraction that represents what traders expect the currency to do. If the ratio goes up, traders are pessimistic and expect the currency to fall. This is helpful, because it is not always easy to quantify what the market is expecting. The put-call ratio puts an objective number on it and lets you know how much change to expect.
Implied volatility is even more arcane and difficult to calculate. For this to be useful, you need a software platform that does the legwork for you. Essentially, implied volatility calculates the likelihood that a given currency will become volatile in the future. For this to work, the tool assumes the Black-Scholes pricing model. Implied volatility works on the assumption that a risk of volatility will be priced into options premiums. Quiet markets will have lower options premiums as a result, indicating a lower implied volatility.
This tool is helpful as long as you don’t make too much of it. Recent studies demonstrate that the method works in the short term—about a month at the most. In the longer term, there are too many uncertainties involved to make a genuinely objective analysis. The benefit of implied volatility is that it helps you quantify your risks before taking on more financial exposure.
So recognizing the power of economic indicators to control the market, how do you respond to maximize your profits?
The most basic idea is to respond more quickly than everyone else. This is why leading indicators are so important. You can make money anytime you have advanced information and can predict the direction a currency pair is going. The degree of confidence you have should be reflected in the amount of leverage you use.
Another way to benefit is by following trends. This is less profitable, but the concept is simply that the market will only realize what is happening gradually. If you see a trend in a currency pair and know that it is happening because of an announcement, you might be able to benefit from the rest of the trend. Be careful, however. This strategy works best when you’ve corroborated the trend by looking at previous announcements. Certain economic indicators drive the market into longer-term trends than others.
On the most conservative side of the scale, the point of economic indicators is to help you evaluate what is really happening in the market and predict a long-term trend in a nation’s economy. This can be challenging because of conflicting reports. You may also find that even if you’re right in the long-term, it can take the market a long time to recognize the facts and move that way. If you plan to use economic indicators this way, be willing to spend a lot of time researching and expect not to see immediate results.
In every case, the key is to be fast, smart, and patient. You will succeed if you can effectively use your knowledge to be just a little bit smarter than the rest of the market.