The Foreign Exchange is subject to changes caused by several factors. Traders must be mindful of these to yield profit and avoid losses.
Volatility is a common forex term.
If you are new to the trade, you may be confused or unfamiliar with this. Volatility is an important consideration when aiming for successful trades.
This guide will teach you what it is, how it impacts the FX market, and how it affects your trading techniques.
What it means: volatile?
Volatile means unpredictable or rapidly changing.
Volatility is the tendency of a substance or a thing to be unpredictable.
What does volatile mean in Forex?
We must understand liquidity first. Let us look at its definition.
Liquidity describes the activity in the market. The more active a market is, the more liquid it is.
Market liquidity can vary from time to time. The number of active and the volume of trade determines the price liquidity.
If you think about it, foreign exchange trade is one of the most liquid markets in the world.
The FX market spans all time zones. The market liquidity may fluctuate as banks open and close.
But it remains active 24 hours a day and five and a half days a week.
And when it comes to volume, the FX market turns over approximately $6 trillion in a day.
So, it is safe to conclude that there is a high volume of trades every day.
Now, let us tackle volatility.
What is volatility?
In trading, it is the degree to which the prices can change drastically over a given period. It is measured relative to the average price.
The sudden changes are called fluctuations or standard deviations.
What is meant by volatile investment?
Volatile investments are assets that have sudden price swings relative to the mean.
These types of investments are riskier because of the uncertainty in the prices.
How does price liquidity affect price volatility?
The volatility of markets is inversely proportional to their liquidity.
High market liquidity will result in low market volatility.
Markets will become more stable. But it does not mean that there are no changes in the prices.
There will still be slight changes. But they will fall within the acceptable average variation.
But, low market liquidity leads to high market volatility.
It will result in drastic price changes.
You can easily observe these changes in the chart. A volatile market will have wild upswing and downswings.
What are the two types of volatility in the Forex trade?
Volatility can describe two aspects of foreign exchange trade.
Market volatility is a more generic term. It is the measure of the total volatility of the Forex market at any given period.
Most of the time, the FX market has low trading volatility because of all the daily activity.
It results in tiny changes up and down changes in the charts.
But there can also be a time when the FX trade can become volatile.
It is because the market can be affected by economic and political changes around the world.
Successful traders are always up to date with current events. It helps them increase their profits and avoid sudden losses.
Currency-pair volatility refers to the measure of price changes for two monetary values.
Like market volatility, the currency pair can change with economic, and political changes.
Both national global developments can also impact it.
Two kinds of Currency-pair volatility
Historical volatility is the past changes in the price relative to the average price.
Implied volatility is a prediction of future price movements.
Market participants give forecasts based on past market activity.
Because of its unpredictable nature, implied volatility is hard to estimate. Frequently, the forecast can be wrong.
Are volatility and risk the same?
The short answer is no.
Although they are closely related, risk and volatility are different.
Volatility is a characteristic of the market that is unpredictable. It is an aspect that is out of your control.
But the risk is something you can manage and avoid. It refers to your exposure to a situation that might lead to a loss or lesser profit.
How do you gauge volatility?
The degree of volatility of a currency pair is reported in percentages.
The higher the percentage, the more drastic the movement of the price in a given period.
Knowing the volatility is vital in trading. It will give the trader an idea of possible breakouts.
Below are several technical indicators that can gauge volatility. These are needles in your barometer (so to speak).
Average True Range (ATR)
The ATR is the mean of the trading range of an asset in a given time.
Volatility is directly related to the ATR.
How does ATR measure volatility?
- If the ATR increases, the more volatile the market becomes.
- If the ATR falls, the market becomes less volatile.
Bollinger bands appear as three moving lines in the chart.
The middle line is called the simple moving average (SMA).
The other two lines run above and below the simple moving average. Each of the two lines is two standard deviations away from the SMA.
How do the Bollinger Bands measure volatility?
- If the outer lines move toward each other, the currency pair is less volatile.
- If the outer lines move away from each other, the currency pair is more volatile.
It may be the simplest of these three technical indicators used in studying the market.
Because it is straightforward, it is commonly used by traders, new and old.
Moving average is the average movement of the prices. It can determine the current momentum of the market.
Three kinds of averages are seen in the charts. All of them help give traders an insight into the current volatility of the market.
- exponential moving average
- weighted moving average
- simple moving average
How does moving average measure volatility?
- If the moving average travels away from the currency price, it shows high volatility.
- If the moving average travels near or goes through the currency price, it shows low volatility.
What are the factors that affect volatility?
Several factors affect the level of volatility between a currency pair.
Let us discuss them.
A country’s political environment has a direct effect on its international trade. Political factors can cause drastic changes in the currency rate.
Political stability can be affected by civil unrest and military invasions.
Foreign investors will shy away from countries experiencing political turmoil and confusion. It will result in fluctuations in the money exchange.
Two competing countries compete and can enforce economic restrictions against each other. It is called a trade war.
It can cause the value of the currency of a country to rise or fall.
Let us cite the recent trade war against the US and China. The war raised the value of US dollars and lowered the rate of the Chinese Yuan.
The Dollar is the currency of the global reserve. The trade war forced investors to dollars and discouraged them from trading the Yuan.
The growth of a nation’s economy will determine the value of its currency in the global market.
A fast-growing economy will project positive data. It will lead to an appreciation of the currency.
The volume of export against imports will impact the currency rate.
A country’s local currency is used to pay for exported goods.
The more products are exported, the more money foreign many that will enter the country.
Inflation and financial policies
Inflation is one of the factors that affect the currency exchange rate. It refers to the rise in the prices of commodities and services.
A country’s central bank tries to control inflation to create economic balance.
If the inflation rate is going up, the central bank will raise the interest rate. And higher interest rate will decrease the value of a currency.
Market attitude toward the currency
People have an impact on the FX market. Market participants drive the market.
Their attitude can raise or lower the currency value.
A positive attitude toward a currency will increase investments. It will, in turn, increase the value of money.
What currency exchange pairs have higher volatility than others?
When we talk of currency pairs, we refer to the rate of exchange between them.
Before we answer the question, let us tackle the different kinds of currency pairs.
There are three kinds; determined by the level of activity or demand of trade.
Major pairs have the highest liquidity.
They are the topmost traded pair. These usually include a pairing of two “safe haven currencies”.
These are the United States Dollar, the Swiss Franc, and the Japanese Yen.
These have a stable value and are projected to increase.
Which are major currency pairs?
- Euro to US Dollars (EUR USD)
- British Pound Sterling to US Dollar (GBP USD)
- US Dollar to Japanese Yen (USD JPY)
- US Dollar to Swiss Franc (USD CHF)
Minor pairs are the second most active currency pair. The pairs consist of other major currencies except for the US Dollar.
What are examples of the minor currency pairs?
- Euro to Pound Sterling (EUR GBP)
- Pound Sterling to Japanese Yen (GBP JPY)
- Canadian Dollar to Swiss Franc (CAD CHF)
Exotic currency pair
An exotic currency pair results from trade between a major and a less traded currency.
What are examples of exotic currency pairs?
- US Dollar to Russian Ruble (USD/RUB)
- Euro to Russian Ruble (EUR/RUB)
- US Dollar to Philippine Peso (USD/PHP)
Now, let us go back to the question.
Which currency pairs have higher volatility?
The key to this question is liquidity. If you remember our previous discussion, liquidity is inversely related to volatility.
The market for major currency pairs is more active. It means increased liquidity. It results in a more stable and less volatile price.
Minor currencies can experience major changes. But most of the time, they are slightly stable.
Exotic currency pairs are the most volatile.
It is because these pairs consist of emerging currencies.
It means that these currencies have fewer trade activities.
What are the most volatile currency pairs in the Forex market?
When the pandemic broke out, it affected global trade.
The lockdown caused drastic economic changes around the world. Some countries suffered more than others. This led to fluctuations in the charts.
Let’s take a look at some currency pairs that have shown the most volatility in 2021.
Australian Dollar vs. Japanese Yen
This pair has a reported average volatility rating of 1.12%.
Japanese Yen remains a stable currency. But the Australian Dollar is less stable.
It may be because its economy is reliant on commodities. Because of the pandemic, there are more restrictions to trade and travel. It causes fluxes in Australian currency.
Australian Dollar vs. US Dollar
The rate of volatility is at 1.07%.
Canadian Dollar vs. Japanese Yen
The Canadian Dollar changes along with the price of the oil.
Since the oil prices have drastic changes amid the lockdown, the value of CAD also goes with it.
British Pound vs. Australian Dollar
After the Brexit referendum, the Pound Sterling has experienced wild swings.
In 2021, it has a reported 1.05 average volatility when paired with the Australian Dollar.
US Dollar vs. Mexican Peso
Although Mexico has a growing economy, it is still volatile. As the Canadian Dollar, it is reliant on oil prices. It causes fluxes in their currency value.
Also, geopolitics with the USA affects the exchange rate.
US Dollar vs. South African Rand
The South African economy highly depends on export.
The current global situation has restricted export activities. It caused a sudden decrease in the country’s GDP, which affected the currency value.
New Zealand Dollar and Japanese Yen
This currency pair has reported average volatility of 1.05%.
US Dollar vs. Turkish Lira
The Turkish Lira is a volatile currency. It is due to political and governmental factors.
What are the least volatile currency pairs in the Forex market?
|Base Currency||Quote Currency||Average Volatility|
|Australian Dollar||Swiss Franc||0.5%|
The contrast in trading high volatile market and low volatile currency pair
Percentage in point (pip)
Pip is the standard unit that measures small changes of currency pairs.
A more volatile currency pair will have more pips than a lesser volatile pair.
Because of the fluxes, higher volatility will have more risks.
But also higher possible rewards. Whereas, lower volatility will mean safer trades but lower profits.
Lastly, volatile currency pairs are more prone to slippage. Less volatile pairs have a lesser possibility of slippage.
Is high volatility good or bad in forex?
Volatility is the price movement.
And price movement is essential to the market. Traders profit from changes in the market value.
When is high volatility good?
Volatility is good for short-term trading.
Day traders and scalpers rely on the hourly and daily changes in the currency pair.
When is high volatility bad?
Volatility is bad if the trader is unable to prepare for the sudden changes.
Each trader’s perception of volatility and its direction is different. If they get it wrong, they can be looking at huge potential losses.
But if the trader can apply risk management actions, he can cut his loss if the worse comes to worst.
Which should you trade: high volatile or low volatile currency pairs?
The answer depends on the trader.
More stable currency pairs are safer to trade albeit with lesser profit.
Volatile currency pairs carry more risks but have the potential to yield more profit.
New traders tend to start trading with less volatile currency pairs.
A more experienced trader will have a better handle on volatile currencies. He will have a more solid plan and can recognize signals earlier.
How do you trade highly volatile currency pairs?
Here are some tips if you are planning to move on to more volatile currency pairs.
Create a specific trading plan
A solid trading plan will lower your risks.
Keep up with the news.
Before you enter a volatile market, do your research. Take a look at the local current events and the global positions of each country.
Study the charts
You have to study the charts and learn how to use the volatility indicators we discussed above.
After this, create a trading plan specific to your chosen currency pair. Your plans should account for wild swings.
Jittery traders have no place in volatile markets.
You cannot trade a volatile currency if you are easily discouraged by fluxes.
Stick to your plan
The volatile markets are suited for long-term trading. So, stick to your plan.
A diary is important in trading. It is useful in keeping track of your current trades and looking back on past trades.
It will help you improve your trading styles.
Volatile markets are highly unpredictable. While the profit potential is high, so is the risk for loss.
Trading with a low position size will enable you to gain with the least losses. If possible, do not trade any amount beyond your deposit.
Place stop losses
Another way of reducing risk is by placing stop losses.
Stop losses enable you to place an acceptable amount of loss in case your strategy fails.
Keep up with economic news.
Be aware of any economic events around that world.
Some traders will play it safe when there is high volatility in the market. But some will take advantage of these movements.
Either way, keeping up with the economic calendar will help you trade better.
If you are trading in a highly volatile market, it is better if you trade fewer currency pairs. This way you can have more control over your trades.
Trading too many pairs can result in oversight.
It is also prudent to keep an eye on currency correlations. Avoid trading too many correlated pairs.
If your common chosen counter currency falls, it can cause a great loss.
Avoid herd mentality
Strength in numbers does not always work. Some traders enter or change their positions solely because others are doing it.
There is a smarter way of doing things.
First, assess the situation. Then use your pre-determined risk management strategy.
Do not easily be swayed by popular opinion. It can cause huge losses on your part.
- Volatility is the standard deviation against the average price in a given time.
- Liquidity has an inverse effect on market volatility. The higher the liquidity, the lower the volatility.
- Volatility can be gauged using the:
- Average True Prices
- Moving Averages
- Bollinger Bands.
- Market volatility is affected by geopolitical, economic, and social factors.
- Major currency pairs are more stable. Whereas, exotic currency pairs are more volatile.
- When trading volatile currencies, you need to:
- keep up with the news;
- create a specific trading plan; and
- apply risk management strategies.
Volatility is necessary to drive the foreign exchange trade.
The up and down movement of the prices opens up windows of opportunity for profit.
The high and low volatility of a currency can be either be bad or good.
It depends on how the trader perceives it and how he manages his trades.