The Informational Role of Forex Option Volume

Abstract

This paper investigates the effect of foreign exchange (FX) option trading volume on the underlying EUR/USD futures market. Our in-sample and out-of-sample tests show that the FX put-call volume ratio can predict future exchange rate changes. Greater put-call volume ratios predict a depreciation of the Euro relative to the US dollar. We use a predictive regression forecast model based on the put-call ratio to propose a trading strategy that performs better than the simple strategy of buying and holding Euros, or than the strategy of trading based on the prevailing mean forecast method. Overall, trading volume in the FX option market seems to facilitate information flow into the underlying FX futures market.

Keywords: G12, G14, G15, G17