July 30 (Reuters) - The FX volatility upon which FX options thrive is an unknown, yet key part of their premium, so dealers use implied volatility as a stand-in. Current levels of implied volatility suggest that Wednesday's Bank of Japan policy announcement poses the biggest threat to short term JPY-related volatility this year.

Overnight expiry is the shortest-duration FX option contract, and therefore any change in its implied volatility when incorporating a major event highlights the additional realised volatility (risk premium) that event is expected to generate. Since including Wednesday's looming Bank of Japan policy announcement, overnight-expiry JPY-related implied volatility has jumped once again to its highest since the Dec. 19 BoJ policy announcement.

Overnight expiry USD/JPY implied volatility was around 17.0 on Monday and reached 28.0 on Tuesday (expiry at 10 a.m. New York on Wednesday). The premium/break-even for a simple vanilla straddle has increased from an already elevated 110 JPY pips to 181 JPY pips in either direction.

For context, overnight expiry USD/JPY implied volatility reached 25.0 before the April 26 BoJ and peaked at 33.0 (213 JPY pips) for the Dec. 19 BoJ.

Risk reversals are an FX option contract that benefits from FX realised volatility in one direction over the other and they show a higher premium for USD/JPY downside, over upside strikes.

The BoJ are expected to announce a reduction in bond purchases on Wednesday and interest rate futures are pricing a 55% chance that the central bank will raise rates by 0.1% to 0.2%.

Beware massive 155.00 FX option strike hedging flows this week nL1N3JM09S

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(Richard Pace is a Reuters market analyst. The views expressed are his own)

((Richard.Pace@thomsonreuters.com))