Forex market volatility isn’t just a simple chaotic change for Forex traders. As market participants try making sense of the price action, trends and patterns actually emerge from those seemingly meaningless swings in value.
What’s market volatility? It’s a measure of the degree that changes in a currency pair, currency, or Forex market’s value as a whole occur. Simply saying, volatility is referenced when sharp changes in the value of a currency are observed as compared to many of the market’s other currencies.
It’s important to note that social, economic, and political events and occurrences affect currencies. They cause prices in the market to become volatile. That being said, traders should keep up on share market news and be mindful of current events to better avoid potential loss and find potential profit. Below are the top three things traders like you should know about market volatility.
1. Market Volatility Has Two Types
Volatility in the market can be categorized into two types. They’re the following:
- Historical Volatility – This type of volatility is calculated from the historical prices. It equals to an asset value’s standard deviation within a specified time frame.
- Expected Volatility – The second type of market volatility is expected volatility. Under the assumption that an asset’s market price reflects expected risks, this type of volatility gets calculated from the current market prices.
2. It’s Possible To Measure Volatility
When it comes to making decisions on closure or opening of currency positions, volatility serves as a very important information indicator for Forex traders. Bollinger Bands, moving average, and average true range are financial indicators that help in appraising market volatility. Popular trading platforms integrate these financial indicators to help in the decision-making process of traders. Learn more about them below.
- Bollinger Bands – Bollinger Bands are exactly designed to measure volatility. These excellent tools are basically two lines that get plotted two standard deviations below and above a moving average for a certain amount of time. Traders can decide for the time frame to be used. For instance, you would have a simple moving average of 20 and two other lines if you set Bollinger Bands at 20. One line gets plotted –2 standard deviations below it, and the other line gets plotted +2 standard deviations above. The volatility is high when the band widens. On the other hand, when the band contracts, it indicates low volatility.
- Moving Average – One of the oldest but crucial volatility Forex indicators is the moving average. It refers to lines drawn on charts that function to provide the average price over a definite time period at a given point. The time frame can be set to weeks, days, hours, or even minutes. That means you’ll get an average of the market movement for the past 30 days if you plot an SMA of 30 on a daily chart. Note that there are different kinds of averages. Simple moving average (SMA), exponential moving average (EMA), and moving average convergence divergence (MACD) are the major types of averages that traders use. These averages function to reduce or eliminate everyday price-movements-related noise. The noise that’s related to the Forex trends, along with the things that are plotted on the charts are also included.
- Average True Range – The last on the list of financial indicators that help to measure volatility is the ATR or average true range. It tells traders the market’s average trading range for X amount of time. Again, the time here is whatever you want to use. The average true range basically takes the distance between the low and high in the time frame being studied or the currency pair’s range. That measurement will then be plotted as a moving average. The ATR would show the average trading range within the last 20 days if you set it to 20. The volatility of the market has been on the rise when the average true range is rising. The volatility is decreasing when ATR is falling.
3. Higher Volatility Makes Trading More Attractive
Rising volatility represents uncertainty and risk. That’s how many people view such a market trend—they often view it negatively. To market players, however, higher volatility is what makes Forex trading more attractive. Contrary to the long-term investors’ buy and hold principle, a major consideration for Forex traders who are more open to risks is the possibility of profiting in volatile markets.
It’s important to understand that volatility just describes an exchange rate’s level of fluctuations. It doesn’t imply direction. That means an increase or decrease in value is more likely to be observed in a currency pair that’s more volatile than others.
In essence, the risk involved in holding a position significantly depends on the currency pair exchange rate’s experienced amount of volatility within the time frame a position is being held. That’s an important factor that traders should take into account when trading. In other words, the swings observed in a currency pair’s exchange rate are what dictate volatility.