Financial markets are, by nature, volatile but when it comes to the forex market, the volatility becomes a reality that all traders learn to live with. There are multiple variables that drive uncertainty and unpredictability while trading in foreign currency.
As forex trading is done between two currencies, called the pairs, learning how to trade volatile forex pairs can give you a big advantage.
What You Should Know About Volatility
Given the dependence that external factors have on a country’s economy and, therefore, its currency, volatility is omnipresent in the forex world. There are multiple factors that influence the performance of a currency. It can be the state of the economy and its various indicators like the GDP, the interest rates and the trade balance, to name a few. Or there could be sudden developments like natural disasters, political instability or even wars or strained relations with neighbouring countries.
Anything that contributes to a negative impact on a country’s economic or political situation can affect the currency. Recent examples like Brexit are a case in point. Likewise, a positive development like healthy economic indicators or even long term political stability can firm up the currency rates of a country.
But, unlike stocks, the forex market cannot be viewed in isolation and a currency doing well or poorly has to be seen in context with the performance of another. As trading happens between two currencies, the comparison will always happen across the pair. That amplifies the potential for volatility in the forex market and trading would, therefore, need to be based on that.
Volatility In Forex Pairs
The volatility seen in financial markets like the stock market is mostly uni-dimensional as the price of a stock needs to be monitored. But, in the forex scenario, the trading happens between two currencies and the complexity doubles with two components becoming susceptible to volatility.
But, even with external factors having an impact on the prices, forex pairs are still mostly driven by aspects of a technical nature that are an integral part of forex trading. Just like with stocks, there is a support and a resistance level that is relevant in currency trading too. Price movement patterns and trend lines are analytical data points that help manage volatility in forex pairs.
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Forex Trading And Volatility
Managing volatility in forex trading can require both experience and understanding of the forex market, in general, and the specific currency pairs. But before getting to the pairs themselves, it will help to get a grip on the basics.
To begin with, every forex trader needs to understand the basic tenets and rules around risk and money management.
High and low volatile pairs
There are high volatile pairs and pairs that are low on volatility. The key here, for beginning traders, is to start with the low volatility pairs and, once comfortable, start trading with the high volatile ones. The more liquid ones or the major currency pairs require experience and a grasp of the market patterns.
Having a trading plan
Forex trading is highly technical and it needs to have a proper strategy and plan. It is safer to follow the trend and not take a contrarian approach. Volatility is a given in the forex market and as long as there is a clear, long-term plan you are working to, short term spikes and blips will not affect it. Instead, trying to react to a volatile market can only result in wrong decisions and losses.
Forex trading, especially with volatile pairs, calls for a huge reliance on technical indicators and analysis. Rely on tools like Average Directional Index and Average True Range, Bollinger Bands and the Donchian Channels, to name the major ones.
These help to identify spikes and help traders trade safely and even course-correct in advance. Being a pro at reading and interpreting chart patterns helps see the larger and long term trend that will, anyway, outlast periodic volatility.
Managing Risk
Risk is inherent in forex trading and the volatile pairs can expose a trader to unforeseen situations. The best way to manage is to comply with the conventional and tested rules of money management and risk.
As is widely used in all forms of financial trading, adhering to stop loss and controlling position size are some of the best practices every trader should adopt and practice in forex too.
Volatile pairs need to have more than the normal stop orders. If the low volatile pairs carry a stop loss of 10 to 20 pips, for the more volatile ones, these should be taken up to about 40 pips. Based on the situation, if buying, stops can be placed below the latest lowest traded price and, when selling, above the highest traded price.
Cashing out
From a safety standpoint, it is a good practice to cash out a portion of your lots when you are in an advantageous position. By doing this, you can register some gains while holding out on the balance of your lots. You can, then, even afford to risk these such that there is either a higher profit or at least a breakeven possible.
Being flexible with trading strategies based on forex pairs
Every pair is different in its volatility quotient and the risks they pose. Approach each of these with the risk to reward ratio. Clearly, the more comfortable you are with a pair, the more flexible you can be with deciding on the pips to be used for stop orders.
Expertise in select currencies and pairs
Obviously, the best way to reduce risk from volatility is to be an expert and even specialise in a currency or its pairs. Rather than being a generalist and trading in all currencies and pairs, it is best to stick to a few but know them inside out.
Follow a currency right from the way it is impacted by factors like the central bank’s decisions, monetary policy, and interest rates, besides the economic and political factors that affect it.
Likewise, this understanding should extend to the various pairs that a currency features in. Having expertise in select pairs even in one currency helps as the correlation amidst each pair can be different.
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Which Are The Most Volatile Forex Pairs?
Let us take a look at the top volatile Forex pairs, the factors that make them a volatile pair, and how to take advantage of the volatility and trade them effectively.
AUD/JPY
Due to the contrasting nature of the economic and trade environment of the two countries, the Australian dollar and the Japanese yen are considered to be one of the most highly correlated pairs to price action.
The Australian dollar, often referred to as a commodity currency, is closely linked to the price and volume of Australia’s exports - the major commodities being minerals, metals and agricultural products.
In contrast, Japan invests heavily in technology.
However, the Japanese Yen tends to hold its value during periods of an economic or political crisis which mostly results in investors selling their assets and borrowing less.
AUD/USD
On the forex market, the Australian dollar's pairing with the US dollar, is considered to be a major pairing as it trades with high volume and liquidity.
This forex pair is high on volatility due to the difference in interest rates between the Reserve Bank of Australia and the Federal Reserve. The interest rate differential has been on a decline due to the current pandemic situations and economic conditions, both in the US and Australia.
Both the US and Australia had been fighting against the Covid-19 outbreaks and their economy’s had taken a significant blow.
GBP/USD
The GBP/USD pair, one of the most popular and volatile forex pairs is also one of the oldest traded currency pairs. Due to the wider price range, compared to other currency pairs, the pair leads to higher spread quotes.
The currency pair is affected by economic indicators and actions by the central banks in both countries. These factors cause high or low impacts on the currency's value. For instance, 2016 saw a sharp decline in the GBP/USD pair when Britain voted to leave the European Union.
NZD/JPY
The New Zealand dollar, similar to the AUD, is a commodity currency and the pairing with the Japanese yen is volatile.
New Zealand’s economy relies on its agricultural and dairy products, and any changes in the prices will influence New Zealand dollar’s value as compared to the Japanese yen.
GBP/EUR
Ever since the United Kingdom’s departure from the EU happened in 2016, the GBP/EUR pair has seen constant volatility, mostly around important economic releases, policy announcements, or when any crucial votes in the House of Commons.
CAD/JPY
Another volatile pair, CAD/JPY, pairs the Canadian dollar and the Japanese yen. The yen, as mentioned earlier, is referred to as a safe haven, and the Canadian dollar is a commodity currency.
The main factor behind CAD/JPY’s volatility is the price of crude oil. The CAD is largely impacted by the price of crude oil and Japan is an exporter of oil. If you are interested in this forex pair, you should keep an eye on the oil market news and prices.
GBP/AUD
The forex pair of the British pound and the Australian dollar has also been affected by the Brexit situation. The price of AUD, being a commodity currency, is heavily linked to the value of Australia’s exports.
Australian manufacturers and exporters used to rely heavily on their trade links with China. Ever since the trade relationships between China and Australia have fallen through, the AUD has been impacted.
USD/ZAR
The volatility in the US dollar and the South African rand currency pair are mostly impacted by the price of gold which is linked with the highs or lows of USD. Gold is one of South Africa’s main exports – so if the price of gold goes up, the price of the dollar increases against ZAR.
If you need to trade in the USD/ZAR pair, study the price of gold and the factors which affect its price before opening a position.
It is crucial that anyone starting off or is a beginner in the forex market should fully understand this inherently volatile domain.
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