Currency volatility in the forex market is defined by frequent and fast swings in foreign exchange rates. Knowing how to trade forex volatility will help you pick which currencies to trade and how to trade them. In this post, we’ll look at FX volatility and how to identify it, the high-volatility currency pairings to avoid, and the methods to use when trading forex volatility.
Volatility: What Is It and How Does It Affect You?
The rate at which the value of an asset fluctuates given a set of returns is known as financial market volatility. It’s frequently calculated by examining the standard deviation of annual returns over a given period.
Volatility is how risky a specific investment is at its most basic level and how it is used in asset pricing to evaluate return changes. That is to say when volatility is high, trading risks are high, and vice versa.
When implied volatility is used to price financial assets, it can help with predicting short-term swings. If the price of an asset fluctuates dramatically over a short amount of time, it is considered highly volatile. The term “low volatility” refers to an item whose price changes slowly over time.
What’s the Connection Between Market Liquidity and Volatility?
To understand the connection between liquidity and the volatile market, you must first understand the definition of liquidity.
What is liquidity?
Liquidity measures how quickly/easily you can buy or sell something in the market. If you wish to buy 100 ounces of Gold, a market participant must be willing to sell this amount of Gold to you.
In highly liquid instruments, this is not an issue. You could execute a EUR/USD trade worth 10 Million during the London market session without difficulties and without moving the market. Timing is essential, though, as currencies might be less liquid during specific sessions.
For instance, if you decide to trade EUR/USD between the closing of US trading and the start of Tokyo trading, you may find that liquidity isn’t as good as you expected, and you may wind up with a weaker execution than you expected.
The lower volatility is, the more liquid a trading instrument is, as it takes a lot more to move it in a given direction. It would require a significant transaction to affect the US bond market or the EUR/USD currency pair in one direction.
Why Is Volatility Important In The Markets?
Uncertainty, volatility, fluctuations, or however you want to call the range of price movement, they’re all part of the game when it comes to trading the markets. There are no price movements if there is no volatility. And there will be no trading activity if there is no price movement.
It’s important to remember that markets require a certain level of volatility to function properly. The problem for traders arises when volatility becomes very high. You must know which currencies are more volatile than others and when volatility is increasing.
What Factors Influence Market Volatility?
Given the interconnected nature of today’s global markets, the streamlined flow of information and communication, and the predominance of social media and digital technology, market experts agree that market volatility is on every trader’s mind now more than at any other time in history.
Let’s look at some of the factors that can influence forex trading.
Politics
It’s easy to see why politics is so important. After all, it makes decisions about taxes, tariffs, trade agreements, and federal expenditures; the government regulates industries and significantly impacts the economy as a whole. When it comes to predicting how reported or genuine legislation will affect business, Wall Street looks to politicians for guidance. Everything from statements to laws to elections can trigger investors to respond in a knee-jerk manner.
Economic Factors
Economic data provides a window into the economy’s general health, much like a doctor’s pulse or blood pressure readings provide a glimpse of a person’s health. The market tends to respond favourably when the economy performs well and meets its goals.
Public Relations Hits and Disasters
Volatility isn’t always market-wide; an individual firm’s stock performance can be affected by whether it receives positive or negative press on a given day — and depending on the size of the company, its performance can have a more significant effect on the markets.
Positive news about a firm, such as a solid earnings report or a new product that will impress customers, helps investors feel good about the company, and they may flock to it, helping to raise the stock price. Negative press, such as a product recall, data breaches, or inappropriate management behaviour, on the other hand, can cause investors to sell their shares, lowering the stock price.
International Volatility
The global economy is more interconnected than ever before, which means that what occurs around the globe has a significant impact on what happens at home. War, political instability, rebellions, regime changes, and other events can affect trade, multinational firms, and the movement of money and investment across countries. As a result, even the slightest suggestion that something is developing on the international stage can create market swings.
Which currency pairs are the Most Volatile?
Some currency pairs have higher volatility than others. Look at some of the most volatile currency pairs below to learn what causes them to fluctuate so much.
AUD/JPY
The currency pair AUD/JPY is seen as a risk indicator. When risk appetite is strong, the Australian Dollar is considered a risk on currency, which means it will be in demand.
On the other hand, the Japanese Yen is a traditional safe-haven currency that will attract a bid when markets are in a “risk-off” mode. As a result, the AUD/JPY is a volatile currency pair, rising when traders are optimistic and seeking risk and falling when traders are risk-averse.
GBP/CAD
The British Pound cross rates are the most volatile among the major currencies. Because Canada is a major oil producer, the Canadian Dollar is another “risk-on” currency heavily influenced by the oil price direction. The Canadian Dollar might be put under tremendous pressure if markets go into “risk-off” mode while oil prices are declining.
On the other hand, the currency tends to do well when traders look for risk and rising commodity prices.
USD/TRY
The Turkish Lira can sometimes experience considerable price swings due to geopolitics and the country’s central bank’s unpredictability and political influence on its trajectory.
Understanding The Difference Between Risk And Volatility
There are some critical distinctions between risk and volatility. Volatility is uncontrollable, whereas risk is; you can choose just how much you are capable and willing to manage with the latter. The two, on the other hand, have a solid bond. Trading volatile currencies are always risky since prices can swing dramatically in either direction. This huge fluctuation can exacerbate both gains and losses.
A prevalent tendency in forex trading is a degree of herd mentality, in which traders opt to take a risk on a turbulent market, partly influenced by the fact that other traders are doing the same. Traders may sell at a lower price in a market crash, potentially losing a lot of money.
You should constantly be mindful of the dangers and assess the benefits and drawbacks of any trade, mainly when the market is volatile. Don’t ever take a risk based on general opinion; instead, use your judgment and individual risk management approach to ensure that you only trade with the risk you can afford.
How Do You Measure Volatility?
When looking for good breakout trade possibilities, we might look at volatility. Volatility is a metric that evaluates the overall price swings over some time and can be used to spot possible breakouts.
Some indicators can help you decide how volatile a pair is right now. When looking for breakout possibilities, these can be extremely useful.
1. Moving Average
Moving averages are the most commonly used indicator by forex traders, and while being a simple instrument, it gives vital data.
Simply said, moving averages track the market’s average movement over a given period, where X can be whatever you wish.
A narrowing of the bands indicates low volatility, while a widening hints at increased volatility.
2. Bollinger Bands
Bollinger Bands are excellent instruments for evaluating volatility because that is what they were created for. This volatility indicator shows whether prices are high or low on a relative basis. The lower, middle and upper Bollinger bands are comprised of three lines. A moving average makes up the middle band. The upper and lower bands are calculated as two standard deviations above and below the MA and are positioned on either side.
3. True Range Average (ATR)
The Average True Range, also known as ATR, is the last item on the list. Because it shows us the average trading range of the market for X length of time, where X is whatever you would like it to be, the ATR is a good indicator for measuring volatility.
ATR depicts the range of a currency pair, which is the distance between the high and low in the time frame under consideration, as a moving average. Setting ATR to “20” on a daily chart will display the average trading range for the previous 20 days.
- When the ATR decreases, it indicates that volatility is reducing.
- When the ATR increases, it indicates that volatility has increased.
Remember that the ATR is a volatility indicator, not a directional one. It’s best employed as a technical indicator to corroborate the market’s enthusiasm for range breakthroughs (or lack thereof).
Using Microsoft Excel to Calculate Volatility
You can use Microsoft Excel to calculate the volatility of a specific currency pair. You’ll need to take a few steps to accomplish this.
Step 1: Decide on a Timeframe
To determine the volatility of a specific currency index, start by defining the time for which the value will be generated. This is entirely up to you, but a 10-day period is a good choice for convenience.
After that, in the Excel sheet, insert all of the currency’s expected closing prices in chronological order. The assumed closing price is when you consider the currency trading day to be over.
This is because the FX market works 24 hours a day and has no closing bell, unlike equity markets, which have a trading activity window.
If you wish to find the volatility over ‘n’ days, you’ll need data for (n+1) days. For example, if you want to assess volatility for ten days, you’ll need data from the preceding 11 days.
The dates should be supplied in the cells in column A, and the estimated closing prices should be put in the cells in column B. Remember to put “Date” and “Closing Price” in the first cell of columns A and B, respectively.
Step 2: Calculate the Daily Returns
The following formula can be used to compute daily returns:
Return = (End Price / Start Price) – 1
To improve the findings and make it more practical, the formula might be updated to:
Return = Ln (End Price / Start Price)
The natural log or logarithm to the base ‘e’ is denoted by Ln. Add the percentage equivalent of Log Returns or Daily Returns for the different dates to the cells of column C. The result returned from this formula is also known as “Log Returns.”
Step 3: Use the Inbuilt Function
STDEV is a built-in function in Microsoft Excel that may be used to calculate the standard deviation of daily return values. The standard deviation is used to calculate the volatility of a currency pair.
To make use of this feature, follow the steps below:
- Select an empty cell with your cursor.
- Press the “=” key.
- Now type “STDEV” in the cell and surround it with an open bracket: (
- Select all of the data values from the daily return column and place them in a closed bracket:)
- Press the Enter key.
Once this process is completed, Excel will offer you the standard deviation value, which is the computed daily volatility.
Conclusion
Volatility is one of the most important concepts to know when trading the financial markets. It’s also a term that investors may toss around without understanding what it means and how volatile markets work. By reading this article, you know precisely how volatility works and how to trade it successfully!