Volatility refers to the quick, recurrent changes to a particular asset’s price. Every market witnesses some degree of volatility. But forex, by its very nature, is volatile. If you understand forex volatility, you’ll know how to handle volatile exchange rates and select the right currencies to trade. Volatility is one of the factors that you should consider when choosing the position size, currency pairs, as well as entry and exit points.
What is Volatility?
Volatility is the price fluctuations of an asset and is measured by the difference between the opening and closing prices across a certain period. It is also defined by how fast prices fall or rise. The market volatility specifically measures the risk in the investment. Usually, the higher the volatility, the riskier a trade is and vice versa.
Measuring The Volatility
You have to assess the price fluctuations over a set period to measure their volatility. For instance, if the exchange rate of a currency pair fluctuates quickly within a short timeframe, it is considered a highly volatile pair. Conversely, if the rate changes slowly over a longer timeframe, its volatility is low.
You’ll notice that the forex market has some currency pairs or certain specific currencies that are more volatile than the others. For example, the currencies of emerging markets or exotic currency pairs, usually exhibit more volatility than the major currency pairs or the safe currencies.
Popular emerging market currencies in forex trade include the likes of Turkish Lira, Indian Rupee, and Mexican Peso. Some of the safe-haven currencies are the Japanese Yen and the Swiss Franc. Furthermore, the US dollar is also sometimes traded as a safe currency.
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What Triggers Price Volatility?
Forex volatility is triggered by numerous factors such as economic factors like interest rate changes and fiscal policy modifications. In recent times, political developments across the globe have also been a factor contributing to market volatility. In short, any factor that influences investor behaviour will trigger market volatility.
It is important to note that for a market to be considered volatile, there should be a price movement (rise or fall) by more than 1% over an extended period.
Dealing With a Volatile Forex Market
Usually, in forex, volatility is a regular feature, and a successful trader can negotiate it properly. A volatile market can be an opportunity to make some profits, but only if you know how to. A common strategy to deal with volatility is to start small and to select your trades wisely. Never enter a trade with overconfidence because the volatile markets are unpredictable. You must be ready to fine-tune and make changes at the drop of a hat. Learn to make decisions without getting emotional. Use logic and the information from your research to decide and stay focused while tracking your trades.
Market Liquidity And Volatility
Liquidity refers to the speed or ease with which a market can execute trades. Usually, it is defined by the entire spectrum of active traders and trading volumes. The forex market is not only highly volatile but also highly liquid. The high liquidity put forex trading in an advantageous position as it is accessible 24 hours a day during the trading days. Over $6 trillion worth of trade happens on the forex market daily.
Market liquidity has a bearing on price volatility. The more liquid the market, the lower the price volatility. This is the reason why the most popularly traded forex pairs such as the USD/GBP do not witness high price variations. However, the exotic currency pairs see more fluctuations because of their lower liquidity.
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Types Of Volatility
Volatility can be classified into the following:
Historical volatility – this measures the past price fluctuations, generally over one year or so. If the price has deviated a lot from its average during this period, the asset is considered more volatile and riskier. But historical volatility does not offer insights into the future trends or price direction. It is a record of what happened in a certain period under certain circumstances and cannot be extrapolated for future price predictions.
Implied volatility – this refers to the method of predicting future prices by assessing options price changes. A rising options price suggests increasing volatility, and vice versa. Implied volatility is also called future volatility.
Market Volatility – this refers to how fast prices change in a specific market. This is marked by high levels of uncertainty.
Predicting A Volatile Market
Although you may not be able to predict the volatility accurately, there are certain ways to assess the probable volatility of the market. They are as under:
Average True Range
Average True Range is an indicator that calculates the true range of prices generated as a 14-day moving average. So, the true range is calculated as the highest value of one of the following three equations:
- True Range = today’s high – today’s low
- True Range = today’s high – previous day’s close
- True Range = Previous day’s close – today´s low
Bollinger Bands
This is another tool to track volatility. It consists of two bands or lines representing the standard deviations above and below a 20-day moving average. The bands expand with higher volatility and thin with lower volatility.
The Cboe Volatility Index (VIX)
This is a method where the market’s expectations for volatility over the coming 30 days are measured. It indicates market uncertainty as a manifestation of the level of expected volatility. It is commonly known as the fear index.
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How To Trade In Market Volatility?
Market volatility is a fact that every trader has to confront sooner or later in trade. Here are some tips to help you trade in a volatile market.
Trade the trend
To trade the trend, you have to observe the market. When it gets near support, expect it to rise and when it approaches resistance, get ready for a drop. Trending markets are easy to spot regardless of the timeframe you look at. Beware that trends can turn up in a two-minute chart and a two-hour chart. It is easy to spot if you pay attention. However, it is not easy to determine the pips you need to gain profits. That’s something you’ll have to learn through experience.
Break free
Most of the time, traders act in herds. Sometimes the levels will break violently when too many traders know of them and stop orders begin to pile up. You can beat this by trying to pick the point where the market might turn around. That way you can trade the breakout. However, the key to it is finding the level you want to exploit and set up the order, keep your stops and targets within the range of spikes.
At the time, it will mean you’ll get just 15-20 pips on a currency pair which moves close to 100 pips per day. But if you are attentive, you can spot the opportunity and breakouts will give you results.
Make an educated guess
If you are up to date with major economic events and breaking news, you can place trades around them. Trading news announcements could turn risky because of the huge moves that follow the news release. However, with ample preparation, you can beat the market.
The key to success is placing your trade before the news hits the world. If you have enough information, you can make an educated guess and plan your moves accordingly. If you know certain news events will affect the market adversely, you should plan your moves to profit from that.
Fill the gap
Although every Friday at 5 pm EST, the forex market officially closes for the weekend, the market is still moving. Prices continue to change based on the events around the world even when markets are closed. It is just that you just don’t see that movement until Sunday at 5 pm EST. This is called the “market gap.”
You can use these market gaps to trade. However, as in the case of other strategies, trading the gap does not guarantee success. So, you must exercise due diligence and caution by placing your stops and targets at reasonable levels.
For instance, consider a scenario where China released some data over the weekend that showed that their economy was contracting more than general expectations. The normal reaction to this news would be the depreciation of currencies of nations that are heavily reliant on trade with China - the AUD being a major currency among them. As the markets are closed for the weekend, you won’t see the movement until it reopens on Sunday at 5 pm EST when the forex market opens for the week.
This result in a phenomenon called the market gap. It is an area on your chart where a candle jumps from one price to an entirely unrelated price without anything in between. Then, all of a sudden, the market might amble its way back to the weekend closing price. This is called filling the gap or closing the gap.
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Conclusion
As you can see there are several ways to trade forex volatility. While none of these methods are foolproof, they certainly carry certain merits you can exploit. However, don’t forget that they also come with high-risk potential. So, you’ll have to be focused and quick thinking to make sure the spontaneity with which you trade does not end up in losses for you. Never trade recklessly and always be quick to cut your losses and exit a trade if it is not going your way. Trading is not a way to get rich quickly. Instead, it will pay you ample rewards if you are patient and consistent over a long period.
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