Volatility is the degree to which prices fluctuate over a given time frame and it is measured as the deviation from the asset’s average price. Volatility is incredibly important in the markets because greater price fluctuations mean a higher the risk of significant losses but also more opportunities for traders to exploit.
In this article we’ll be examining what volatility is, what causes it and how to measure it as well as providing some valuable tips on the best strategies to implement in periods of low and high volatility.
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What Is Volatility in Forex Trading?
In Forex trading, volatility is the rate that currency pairs fluctuate over a set period. So, the price of a currency pair will move at a much faster rate over extended ranges when volatility is high and will move slower in periods of low volatility. Forex generates very high levels of volatility about 30% of the time and can produce extremely sharp price spikes during these periods.
Some of the highest volatility currency pairs at any time are AUD/JPY, NZD/JPY, and GBP/EUR, whereas some of the lowest volatility pairs are USD/CHF, USD/JPY, EUR/CHF, and USD/EUR, as they are often moving in the same direction.
What Causes Market Volatility for Currency Pairs?
Volatility is an indicator of market uncertainty, which leads prices to become unpredictable. Causes can include monetary policies like interest-rate levels set by central banks, market sentiment and geopolitical factors like trade agreements.
Another factor that can impact volatility is liquidity, the speed at which an asset can be sold. Market volatility and liquidity are closely related. Low liquidity is an indicator of high volatility, whereas high liquidity means a more stable price and lower volatility
What Indicators Should Be Used to Measure Forex Volatility?
All of the following are great indicators to use when measuring market volatility: Bollinger Bands, Volatility Index (VIX), Keltner Channel Indicator, Donchian Channel Indicator, the Chaikin Volatility Indicator, theTwiggs Volatility Indicator, the Relative Volatility Index (RVI), and the Average True Range Indicator (ATR).
Let’s use this last as an example. The ATR reflects the market average trading range for the chosen period. So, if you set the ATR to 14 on your daily trading chart then you will see the average range over the past two weeks.
How to Trade When Volatility is High
You should always adhere to your Forex trading strategy, but especially during volatile periods. Price movements can be so rapid that you cannot allow even the slightest emotional reaction to interfere with your Forex trading decisions. As a major priority, you need to control and lower your risk exposure as the pressure intensifies. Unless you impose strict self-control and discipline, the sheer speed of events could overwhelm you resulting in serious financial losses.
To counter the effects of volatility, you must focus on the key elements of your Forex trading strategy such as its money management concepts, risk control benchmarks and contingency plans. For example, you should consider using tighter stops to reduce your risk of financial loss. While this means you could be stopped out quicker because of sharp price movements, you are still well-advised to expose less of your trading balance under these conditions.
You can achieve this objective by employing smaller stops together with reduced lot sizes. You should aim to risk no more that 1% of your entire budget when Forex is volatile. You could still realize good profits because the size of your wins could be greater because of the increased price movements.
You could research and perfect this concept by bench-testing different stop values during previous periods of high Forex volatility. For each configuration you choose, you need to calculate its win/loss ratio and expectancy values so that you can compare them to others. You will eventually hone into the best stop value by utilizing this approach.
Forex Market Volatility Trading Tips
Here are some useful tips for safely navigating a highly volatile market:
Manage Your Risk
The first thing that you need to pay attention to is risk. If the situation becomes increasingly volatile, then protecting your capital becomes even more important, and you should examine your trade size. For myself, one of the most effective ways I have found to protect trading capital in a volatile situation is to cut the position down. In other words, if you typically trade 0.5 lots, then you may wish to trade 0.25 lots because of the inherent risk in a market that can move very rapidly.
Lessen Risk, Lower Leverage
Most brokers offer very high leverage, but you do not have to use it. There are brokers allowing position sizes of 1 penny per pip. Professional traders tend to use no more than 3 to 1, which would prevent a scenario where a single trade wipes out an entire account.
Trade Longer-term
When trading in a volatile market, the overall trend becomes much more important. While volatile markets typically denote some type of trend change, the reality is that the longer-term trend tends to be what the market pays attention to overall. Because of this, if you are in a volatile market you may wish to only trade in the direction of the longer-term trend, meaning that you need to sit on your hands occasionally. Sometimes, the best thing to do is wait for the larger money to come in and push prices in the right direction, as well as keeping your trade position smaller, because of the potential of losses.
You should however have a “line in the sand” when it comes to the longer-term trend and recognize that a break down below or above that line represents a change. Once the longer-term trend changes, it alters the overall strategy. Your assessment should be based upon weekly, if not monthly charts. While this could cause a lot of short-term pain, most of the time, the longer-term trend eventually reasserts itself.
Sometimes, It’s Better to Sit on the Sidelines
Ultimately, a lot of traders become overly attached to a particular currency pair. If you are typically a trader of the GB/EUR pair, then you should perhaps look to EUR/CHF or even turn to another market for a while, if it has become too volatile.
Use Higher Time Frames
Another tip for when the market becomes volatile is simply go to higher time frames, which will naturally make you cut down your position size. For example, you may typically trade the hourly chart and risk something along the lines of 50 pips on average. However, if you are forced to trade the daily chart, you may need to risk 120 pips on average. You still want to risk the same amount of capital per trade, so you will have to start out with a smaller position. This forces you to focus on the big picture and pay attention to the overall attitude of the market instead of the day-to-day noise.
Switch Off the News
You should be cautious about paying too much attention to headlines. What should concern you is where prices are going, not the market response to a single political announcement. The news cycle is brief and should not be the basis for your strategy. Markets are truth, and truth can be found in pricing. Beyond that, when things get too volatile you will find analysis loses its value rapidly, becoming less useful after just a few hours. You need to look at the big picture in these situations, and simply relax.
How to Stop Your Account Blowing Up in a Wild Market
What can traders do to protect themselves from being wiped out by a sudden and huge fluctuation in the market?
Use Guaranteed Stops
Some brokers offer guaranteed stops. It comes at a price, as you have to pay a higher spread and/or commission on the trade. Usually, even over periods of several years, traders using guaranteed stops on every trade will come off worse than traders using normal stops which might suffer from slippage. However, guaranteed stops do provide a protection against a “black swan” move in the market.
Question if a Currency is Prone to a Sudden Huge Move
Trading all the time with guaranteed stops and very low leverage is probably too much to ask from most retail traders. However, it is possible to identify any specific currencies that are prone to a dramatic movement following even a single announcement by their central banks, and trade those specific currencies with guaranteed stops or very low leverage.
Major News Releases and Forex Volatility
Forex becomes extremely active about the scheduled times of very important economic announcements. This is because exceptionally large volumes of orders are being presented for execution within a very short time frame. Depending on your broker, there is a danger that your order could be overlooked swamped by the frenzy of activity and may not be executed until sometime after the market has surged past your selected opening price. During serious fundamental releases when Forex volatility is extremely high, there may not be enough liquidity in the market to fill all the orders at the price points displayed.
Volatility Clusters
The pioneering work of Benoit Mandelbrot identified a prevalent phenomenon in financial markets: volatility clustering. What this means is that when volatility is relatively low, it is more likely than not to remain low the next day, and the same follows then volatility is relatively high. Traders have tended to exploit this by watching for a sudden explosion of volatility in a quiet financial instrument – traditionally, a breakout. They then buy in and hang on until the volatility starts to die down again.
Let’s view two major currency pairs and see how this phenomenon works in Forex. We will measure the autocorrelation of the daily price movements of EUR/USD and the GBP/USD between 2002 and 2017. A result of 1 would be a perfect positive correlation, with -1 being a perfectly negative correlation. The results were:
EUR/USD: -0.03
GBP/USD: 0.02
This suggests that whether the price moves up or down today can tell you almost nothing, by itself, about the direction it will move tomorrow.
However, if we use absolute values and therefore simply measure whether the size of today’s price movement tells us anything about the probable size of tomorrow’s movement – whether up or down – we get some markedly different correlation coefficients for the two currency pairs using the same data and same period:
EUR/USD: 0.09
GBP/USD: 0.14
This data suggests that while the effect might be relatively small, it exists.
How can volatility clustering be used practically to help with trading?
When you see a sudden large price movement, keep in mind that another large movement is more likely to happen today. This means that you should widen your “normal” stops considerably. It also means that if you are long, you should not panic at a strong pullback, and if you are short, you should be going for more than just a few pips.
Don’t forget that the “real” commission you pay by way of the spread goes down as volatility goes up.
Bottom Line
As we have seen, to successfully navigate Forex market volatility, it is essential to manage risk effectively. This involves using the right indicators to gauge volatility and then adjusting your trading approach accordingly. Ultimately, your success at capitalizing on the opportunities this presents and mitigating your exposure depends on your experience and risk tolerance. However, its high volatility is what makes the Forex markets so incredibly exciting and dynamic for all types of traders.
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