Our DailyFX volatility indices continue trending lower, but a sharp jump in Japanese Yen volatility expectations have boosted broader market forecasts. Though the downtrend in volatility expectations would normally signal markets are gearing up for lackluster price action, a recent pickup warns of short-term breakouts within wide trading ranges.

Euro/US Dollar Options Analysis

The Euro/US Dollar recently hit a powerful bullish extreme on its run up to year-to-date highs, and we have consistently favored EURUSD declines through the past several weeks of trade. The fact that COT net Non-Commercial longs recently eased off of extremes adds weight to the argument, and we likewise note that both 1-week and 3-month Risk Reversals are considerably off of their highs. Though we may need to wait for a significant bounce in volatility expectations to call for a Euro breakdown, our options sentiment-based EURUSD forecast remains bearish.

British Pound/US Dollar Options Analysis

Forex Options-based outlook for the British Pound/US Dollar pair remains similarly bearish, and a major sentiment extreme threatens to derail GBP strength. In fact, recent CFTC Commitment of Traders data showed that traders hit their most net-bullish levels since the GBPUSD traded near 2.00. The subsequent pullback in positions warns that traders may soon unwind overextended GBPUSD longs. Important technical support at the 1.6000 mark suggests bulls won’t give up without a fight, but our medium term bias remains bearish.

US Dollar/Japanese Yen Options Analysis

FX Options and Futures Trading markets have seen a substantial shift in USDJPY sentiment, with traders now very aggressively betting on Japanese Yen strength. Last week’s tumbles in Yen crosses put many traders on the defensive—buying JPY against almost all major currencies. Tellingly, Net Non-Commercial positions in the USDJPY grew to the most net-short since mid-March. At that point the USDJPY set an important multi-month bottom and rallied considerably. Yet we believe that risks remain for a further USDJPY breakdown through the near term.

US Dollar/Canadian Dollar Options Analysis

Traders essentially maintain fairly neutral sentiment on the USDCAD, and we have no strong COT or Forex Options-based bias on the recently-volatile currency pair. Indeed, we have noted that the pair has largely been correcting from impressive sentiment extremes seen through mid-May. Recently sharp declines have left fast-moving Forex Options risk reversals noticeably lower, but the broader trend continues to favor USDCAD gains. Absent a substantial shift in COT or FX Options positioning, we will remain neutral-to-bullish the USDCAD through the near term.

US Dollar/Swiss Franc Options Analysis

A sharp shift in Forex Options risk reversals projects that the USDCHF may rally through upcoming trade. Indeed, options traders are now the most bullish the USDCHF since mid-April. Of course, it serves to note that bullish options market sentiment did not translate into USDCHF gains through that period; a substantial shift led to an approximate 1000-pip decline. It will be critical to watch whether this time will be different. Though we do note that COT Net Non-Commercial positioning remains extremely bearish, and short-covering could easily lead to CHF weakness.

Australian Dollar/US Dollar Options Analysis

We have been calling for a noteworthy Australian Dollar correction for weeks now, and we are finally seeing signs that the AUDUSD could see a sustained pullback. Forex options market risk reversals have essentially turned on a dime, easing off of significant sentiment extremes following a financial market-wide correction in risky asset classes. At the same time, COT data shows that Non-commercial traders remain extremely net-long the high-yielder. A pullback in positions could further fuel AUDUSD weakness.

New Zealand Dollar/US Dollar Options Analysis

The New Zealand dollar/US Dollar pair is quite similar to the AUDUSD, with significant sentiment extremes leaving the door open for further near-term declines. As of last week, Net Non-Commercial positioning on NZDUSD futures remained the most net-long since the pair set noteworthy tops in July, 2007. Already we see that traders have pulled back on extremely one-sided sentiment. Yet we see room for further corrections and accordingly remain bearish.

Written by David Rodríguez, Quantitative Strategist for DailyFX.com, drodriguez@dailyfx.com