Forex and volatility go hand in hand like love and marriage. Volatility amplifies the risks in foreign exchange trading but without it, there’s limited potential to make decent profits. If traded correctly, volatile instruments can yield high returns.
In this in-depth guide you’ll learn:
- What is volatility in the forex market
- Difference between liquidity and volatility
- Historical versus implied volatility
- What is a volatility trading strategy?
- How to recognize a volatile currency
- 3 top tips for trading volatility
- Useful indicators for volatility trading
And lots more…
Let’s dive right in…
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Forex traders who trade on volatility trade on the unpredictability of the instrument rather than the price itself. They concern themselves with how much the price of an instrument will move rather than in which direction it will move.
What is volatility in the forex market?
👉 Volatility is the rate at which the price of a financial instrument increases or decreases in response to market conditions. It’s measured by calculating the standard deviation of annual returns over a set period of time.
👉 High volatility is wide price swings on an asset in a short period of time. Low volatility is shallow swings on an asset, where it changes in value at a steady pace over a period of time.
👉 In the forex market, all currencies experience volatility but some pairs are more volatile than others. This has to do with the intrinsic nature of the principle economies that they represent and how susceptible they are to market events and circumstances.
Difference between liquidity and volatility
👉 Liquidity describes how active a financial market is and the total volume that is traded daily, monthly, or annually. Volatility refers to how dramatic the price movements are in different market conditions.
👉 Forex is one of the most liquid financial instruments because it’s traded 24 hours a day/5 days a week. Between 5 to 6 trillion US Dollars are traded on the forex market every day, making it one of the most liquid assets on the global market.
👉 Market liquidity impacts market volatility. Low liquidity results in a more volatile market (prices change dramatically) and high liquidity results in a less volatile market (prices keep steady).
👉 In the highly-liquid forex market, you have many traders moving smaller increments at the same time which usually results in prices moving up and down steadily. Drastic price movement (high volatility) in certain currencies usually only occurs in response to political, economic, and social events.
Historical versus implied volatility
👉 Volatility is viewed as historical or implied and both are measured in percentages on an annual basis.
➡️️ historical volatility (HV) is the actual volatility confirmed over a period of time, and monthly or yearly
➡️️ implied volatility (IV) is the level of volatility that is inferred by the current option price
👉 Implied volatility is deemed more relevant than historical volatility as it reflects current sentiment while historical volatility looks at past sentiments.
👉 When political, economic, and social events occur, volatility often spikes and traders focus on implied volatility, making inferences on the direction the price will move based on current market conditions. When the market is calm or uneventful, traders rely on historical data to predict volatility.
What is a volatility trading strategy?
👉 All currencies are subject to volatility, some more than others. Technical analysis helps traders pick up the telltale signs of price movements so they can prepare for these movements using useful indicators adopted as part of a tried-and-trusted volatile trading strategy.
👉 A volatile trading strategy involves keeping up-to-date with current affairs and world events and studying currency characteristics that make them susceptible to wide price swings.
👉 Forex brokers who trade in volatility jump into the market when high volatility arises. Those that don’t, tend to avoid active trading under high volatility conditions to limit their risks. High volatility amplifies profits if things go your way. Avoiding high volatility means opportunities to maximize profits are reduced.
👉 There are well-established trading strategies for trading in times of high volatility as well as plenty of technical indicators that help traders minimize their risks and maximize their profits.
How to recognize a volatile currency
👉 In general, highly volatile currencies trade within a range for a period of time but they are prone to breakouts and unpredictable price movements. The currency prices move quickly and forex traders are at risk if their trade is not executed at the entry or stop-loss point.
👉 High volatility currencies require a trading strategy that allows for rapid adjustments that ‘get you in and out’ of a position at the right time to minimize risk and maximize profits.
👉 One tactic involves widening the placement of stop losses by a factor of 2 or 3. A stop-loss size of 20 pips should be increased to 40 or 60 pips. Investors trading in volatility can also manually adjust the stop loss in the direction of their profit target.
👉 Another common tactic is to reduce the size of a trade-in relation to the overall account balance. If a trader’s risk threshold in stable market conditions is normally 4 percent of their total trading account balance, he or she would reduce that to 2 percent in high volatile market conditions to cut their exposure to losses.
Stable currencies
👉 The following currencies have proven to have greater stability, largely because they’re associated with governments that maintain sound public sector accounts and have limited influence on market affairs.
➡️️ British Pound
➡️️ Chinese Renminbi
➡️️ Euro
➡️️ Hong Kong Dollar
➡️️ Japanese Yen
➡️️ New Zealand Dollar
➡️️ Norwegian Krone
➡️️ Singapore Dollar
➡️️ Swiss Franc
➡️️ US Dollar
Volatile currencies
👉 Volatile currencies are typically associated with major emerging markets where governments have a strong influence on market affairs and the currencies are negatively affected by contentious policy shifts and global supply and demand factors.
➡️️ Argentine Peso
➡️️ Brazilian Real
➡️️ Mexican Peso
➡️️ Russian Ruble
➡️️ South African Rand
3 top tips for trading volatility
👉 It’s recommended that beginner forex traders avoid trading in volatile market conditions. It’s best to take a long-term stance on positions where dramatic ups and downs are organically flattened and profits materialize.
👉 However, the forex market is volatile in nature and at some stage, you’ll need to adapt your personal trading strategy to deal with volatility. Here are a few handy tips to weather stormy forex waters.
1️⃣ Trade the trend
When the market approaches support, prepare for it to rise. When it approaches resistance, prepare for it to drop.
Trending markets are fairly easy to read, regardless of the timeframe. A trend is where prices typically move in a particular direction over a given time period. Correctly reading a price trend puts you in a strong position to identify profitable entry and exit points.
2️⃣ Take the path less traveled
When the forex market breaks unexpectedly, many traders follow the herd. They stop positions and re-enter when the market stabilizes.
Trading through volatility involves finding an opportunist price point, entering a position before the forex market reaches it, and going for pips on currency pairs that yield profits.
3️⃣ Make an educated guess
Keeping scrutiny on the leading world and economic events means you can be proactive in trading through potential volatility. This involves a strategy of trading news announcements, where you can make an educated guess on dramatic price breakouts.
Useful indicators for volatility trading
👉 All currencies experience volatility but some currencies are typically more volatile than others. Stable currencies are associated with economies that have low inflation, stable trade and balance of payment indicators, diversified production of goods and services, stable political systems, a predictable monetary policy, and balanced government accounts.
👉 Volatile currencies are associated with opposite economies. When one or more of the above characteristics are unstable or unpredictable, you’re likely to find the currency is more volatile. In this case, volatility is influenced by either internal or external market conditions.
👉 A currency is considered volatile if it routinely experiences steep highs and lows. There are several technical indicators that help traders identify signs that a currency is experiencing typical or atypical volatility.
➡️️ Average true range indicator (ATR)
This is the most popular indicator used to compare high and low prices in a trading period with highs and lows in a previous trading period. The indicator detects whether the range of prices has widened and it tracks movement in pips proportionally.
➡️️ Bollinger bands
Bollinger bands form part of technical analysis that involves volatility charting. The band method is used to compare price variations that are represented by upper and lower lines on a chart.
The price variations are compared against a 20-period moving average which is shown as a centerline. The outer bands widen as volatility increases and narrow as it declines.
➡️️ Keltner Channel
The Keltner Channel involves analysing price movements relative to the lower and upper moving averages for a particular forex currency pair. It’s a combination of the ATR and the exponential moving average (EMA).
Keltner Channel charts look similar in appearance to Bollinger Bands but the range is narrower. Traders look for price movements that break above or below the lines in the Keltner Channel.
Volatility squeeze is a combination of the Bollinger Bands and the Keltner Channel. It’s useful for identifying a possible breakout for a currency pair and identifying an entry or exit opportunity. The volatility squeeze happens when the Bollinger Bands move inside the Keltner Channel.
➡️️ Momentum Indicator (MI)
The Momentum Indicator is available on MetaTrader 4. It’s also known as the Rate of Change Indicator.
MI is used to analyze the speed and strength of a price movement; where the more positive the number is, the stronger the upward trend for the currency pair. When the MI is negative, the currency pair’s downward trend is stronger.
➡️️ News watching
Watching the media for breaking news or warnings of political, economic, and social events is an age-old approach to forecasting currency volatility. Keep tabs on macro events such as war or natural disasters (the likes of the pandemic) and micro-events such as current account deficits, civil unrest, or economic downturns.
➡️️ Relative strength index (RSI).
Another popular indicator is the Relative Strength Index (RSI) which measures the strength of a trend over a set number of recent trading periods. The more dominant the movement is in a set period of time, the further the currency price is likely to move. The currency price may even reverse.
➡️️ Strong and weak analysis
This method is used to identify the potential of volatility in a currency. A group of currencies is compared against a relatively stable currency base over a set period of time. The stable base currency used most often is the US Dollar.
This technical analysis ranks the group of currencies in order of strength and weakness. Currencies are regarded as volatile if they consistently show weakness over time.
➡️️ Volatility 75 Index (VIX)
The Volatility 75 Index (VIX) is published by the Chicago Board Options Exchange. It’s an index that measures the volatility of the S&P500 stock index and identifies the 30-day implied volatility which is based on options prices.
Known as the ‘fear index’ or ‘fear gauge’, the VIX essentially measures the level of fear or complacency in the market. The higher the value of the VIX, the higher the fear. The lower the value of the VIX, the lower the fear which shows a level of complacency in the markets.
VIX is primarily used to evaluate options but it has in recent years been extended to cover underlying instruments such as forex and commodities. It’s an excellent index to use during market turmoil when the forex market is volatile.
Interpreting the Volatility Index (VIX)
👉 There are several useful indicators one can use to determine near-term volatility but the Volatility Index (VIX) is regarded as the leading indicator of market volatility and investor sentiment. It tracks implied volatility and gauges the level of fear or complacency among forex brokers and investors, although it does not indicate future market direction.
👉 The VIX is calculated by finding the midpoints of real-time S&P 500 option bid and ask prices. The volatility value is derived by aggregating the weighted prices of S&P 500 puts and calls over a wide range of strike prices.
👉 A typical indicative value is 30.
👉 When the VIX reading breaks above 30, it indicates high volatility and inherent fear in the markets. At this level on the VIX, forex brokers and investors would trade with caution.
👉 When the reading drops below 30, it indicates stable market conditions and a degree of complacency. At this level on the VIX, brokers, and investors trade with a higher degree of confidence.
👉 The VIX is particularly useful to determine seasonal patterns that are dictated by economic events such as the reporting season. Sustained low levels in the VIX alert investors to a change in mood in the markets that fall outside seasonal expectations.
IN SUMMARY
👉 Trading volatility is a strategy best left to experienced forex traders, in a particular day or short-term traders. Many traders rely on volatility to maximise profits from rapid price swings in the forex market. However, most traders are content to trade in less volatile market conditions to limit their risks.
👉 Forex traders and brokers following a volatility trading strategy use a collection of useful volatility indicators that are proven to help charter stormy waters. The high-risk aspect of volatility trading may result in high rewards but it has the potential to amplify losses.
👉 Low risk and low volatility trading strategy reflect a strict and disciplined approach to forex trading. Forex traders who adopt a low-risk trading methodology may not achieve high profits in the short term but then, they are less likely to suffer high losses.
Disclaimer
Trading foreign exchange on margin carries a high level of risk and may not be suitable for all investors. Forex trading involves a high degree of leverage which increases the risk associated with forex trading.
Forex and volatility go hand in hand like love and marriage. Volatility amplifies the risks in foreign exchange trading but without it, there’s limited potential to make decent profits. If traded correctly, volatile instruments can yield high returns.
Forex traders who trade on volatility trade on the unpredictability of the instrument rather than the price itself. They concern themselves with how much the price of an instrument will move rather than in which direction it will move.
