Analysis of historical data shows the level of a currency pair's volatility can be used to indicate what type of strategy fund managers should use. Jessica James, a director in the risk advisory group at Citigroup in London, presented statistical analysis showing a combination of option-selling and trend-following models produces greater returns than either model by itself. The analysis also indicated volatility levels can be used as a 'switch' for the model.
This combined model can produce an average annual return of around 10% for the U.S. dollar/Swiss franc for example, while a trend following model produces around 4%, or below 1% for an options-based strategy alone.
James suggests fund managers make a decision to follow either strategy depending on whether one-month at-the-money volatility is above the trailing five-year average. If it is, managers should sell option structures such as one-week straddles. If one-month is lower than historical levels, then managers should take either a long or short position in the underlying currency depending on whether the spot rate is above or below its 80-day average.
