What Is Volatility And How It Affects Your Forex Trading?

In the simplest form, volatility is the rate at which market prices change. Large price movements equal high volatility while small price movements mean low volatility.

A high volatility situation would be EURUSD moving 200 pips in one hour; a low volatility occurrence would be EURUSD moving 50 pips over 24 hours. You can see that the two factors are the value of the price change and the period.

Large price change + short time period = High volatility

Small price change + long time period = Low volatility

Volatility in the Forex market

Forex trading comes with less volatility than other markets, since price changes are considerably smaller, nevertheless to be a successful Forex trader you must take volatility into account.

Another distinguishing factor in Forex is that volatility is considered equal in bullish and bearish markets, other markets (such as stocks and indices) tend to have higher volatility in bearish conditions. 

What causes high volatility?

How to gauge volatility?

Before discussing the methods I should mention there are two types of volatility. Firstly, there is historical volatility which is calculated based on fluctuations from the past. Secondly, implied volatility estimates future volatility, which is calculated using futures options.

Methods:

  • Calculating standard deviation from the historical mean, greater deviation from the mean depicts higher volatility.
  • Percentage price change over a given period is also a great indication, a high % change (compared to the norm) means high volatility.
  • The volatility index (VIX), a derivative of S&P 500 options, is widely used by traders as a representation of volatility. Although it has nothing to do with Forex trading, it is a great indication of general trader psychology and participation levels (hence the nickname “fear index”).

 

Volatility index (VIX)

(Source – TradingView)

 

High VIX valuation = High volatility

Low VIX valuation = Low volatility

 

  • The average true range (ATR) indicator shows the markets range for a specified period, making it a great tool for determining volatility. It is also accessible since most brokers, including our partners Plus500, provide this tool on their platforms.

 

Average true range (ATR) indicator

During the highlighted period, the ATR indicator trended up due to large price moves. Once it was calmer, and the price range decreased, the indicator fell.

 

Increasing ATR = Increasing volatility

Decreasing ATR = Decreasing volatility

How it affects your trading?

Volatility has a direct effect on risk in every market therefore you need to understand and adapt to changes in volatility to manage risk correctly.

Higher volatility leads to greater risk. Most traders run away from volatility because of this, they are missing something though… if volatile markets equal more risk, they also hold greater opportunities to make profit.

The key is to adjust for volatility instead of being fearful of placing trades, it sounds easy enough but how can you do this? By sizing your positions correctly and taking volatility into account when setting your stop losses.

In closing, unseasoned traders may believe volatility is evil because (in itself) it cannot be managed, however, with proper money management it can be used to make larger profits (exactly what a trader wants to hear)

 

Keep in mind…When markets are volatile, so are emotions.

Happy Trading.

 

Risk disclosure – Trading CFD’s carries risk, losses can exceed deposits.

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