Forex Market Volatility
In currency trading, volatility plays a crucial role in determining trade opportunities. It directly affects your profit or loss from a trade. So, understanding the concept of market volatility is a must before starting trading. In this article, we will learn about volatility, its types, and how to manage it.
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Volatility refers to the frequency or degree of change in the value of a financial asset over a period. It is the measure to define how quickly the price of the asset changes.
EUR/USD, USD/JPY, GBP/USD, EUR/JPY, NZD/USD, and USD/RUB are some examples of highly volatile currency pairs.
- Historical volatility
- Implied Volatility
- Economic Policies and announcements
- Manmade and natural events
- Liquidity
- Market Sentiment
What is Volatility?
Volatility refers to the frequency or degree of change in the value of a financial asset over a period. It is the measure to define how quickly the price of the asset changes.
In foreign exchange market, volatility is the magnitude of price fluctuation of a currency pair over a particular period.
Higher and bigger price swings over the short period represent greater volatility, while lesser or stable price swings represent low volatility.
USD/JPY, GBP/USD, EUR/JPY, NZD/USD, and USD/RUB are some examples of highly volatile currency pairs, while EUR/CHF, AUD/CHF, GBP/CHF, EUR/GBP are of low volatile pairs.
Types of market volatility
Historical volatility:
As the name suggests, the price fluctuation of the financial asset is calculated based on historical data. The method focuses on past data; therefore, traders keep an eye on past trends to predict future movement.
Implied Volatility:
Compared to historical volatility, implied volatility is more popular amongst option traders due to its forward-looking approach. It is based on estimating or predicting future price trends regardless of past data.
What causes changes in volatility
Market Volatility is a crucial aspect a trader should consider for making a trade decision. Let us learn about the factors that cause changes in the volatility of a currency pair.
Economic Policies and announcements:
Forex Trading is not regulated by any particular institution. However, the respective nation’s government or central banks may create or change policies that directly or indirectly affect currency trading.
Changes in interest rates, monetary policy, inflation reports, employment rates, and other economic data result in sudden and unexpected price fluctuations in the market.
Manmade and natural events:
The volatility of a currency pair is also affected by human and natural occurrences like wars, diplomatic tensions, earthquakes, floods, etc.
These unexpected events have a major effect on the value of respective currencies. Let us understand it by example: Russia Vs. Ukraine’s war significantly affects global trade, commodities market, and technological and infrastructure development in the nations.
According to the reports, the Russia and Ukraine war adversely affects the global currency market. Due to this war, the Russian ruble saw a major decline in value against US Dollar.
Liquidity:
Liquidity measures how quickly one can buy or sell financial instruments in the market. The foreign exchange market offers great liquidity.
Liquidity and volatility have a great relationship and are interdependent market factors. High liquidity may result in low volatility, while low liquidity may result in high price swings and great volatility.
Market Sentiment:
Another crucial factor that causes price swings in the foreign exchange market is traders’ sentiments. Currency trading is influenced by what the majority of people think about the market.
Positive or negative perceptions or opinions about the currency pair result in price fluctuation. That’s why sentimental analysis is considered important in currency trading.
How to trade volatility in forex
Knowledge of volatility is a must for identifying trade opportunities in the market. Let us discuss how you can use and manage volatility to trade efficiently.
Identifying potential opportunities:
You can select a currency pair, considering how volatile it is. Highly volatile pairs are quite risky to trade in because both the profit and loss are large.
Trend traders, price action traders, scalpers, and day traders benefit from an asset’s volatility and make decisions accordingly.
Order Management:
You can set the crucial or pivot points of your trade considering volatility. It will help you to identify the stop loss and take profit levels, support, and resistance points.
Keep a watch on economic events:
News, economic reports, and announcements have a major and immediate impact on volatility. Measuring and predicting volatility can be challenging for traders.
However, keep an eye on financial news and economic calendars. You can predict price fluctuation more efficiently and learn how to manage your trade accordingly.
Risk Management:
Volatility helps you maintain the risk-to-reward ratio and limit the leverage ratio. Highly volatile financial instruments are unpredictable and sensitive to changes.
You can formulate your money management strategies considering the volatility. Remember, trading based on volatility eliminates the chances of huge losses.
Consider Trading Sessions:
The volatility in the forex market also differs based on the time frame you are trading in. There are four sessions, which include London, New York, Tokyo, and Sydney Session, and each is open for a different period.
So get yourself well-versed with when the forex market opens to manage volatility. The overlapping time of the European and American sessions is the most volatile period, while the Asian session offers low volatility
Bottom Line
Understanding the concept of market volatility can be difficult for novice traders. However, once you learn to manage volatility in forex, you will enjoy using it.
The unexpected, sudden, and large price swings may affect your whole trading plan and give birth to fear in the trader’s mind. Therefore, volatility is a must to trade with the right psychology and effective strategy and maintain the emotional balance.
You can also go for fundamental and sentimental analysis to measure volatility. In addition to this, using charts and technical analysis indicators to calculate and manage volatility increases the chances of positive trade outcomes.