Volatility is the frequent and rapid changes to a particular asset’s price. By understanding forex volatility, you can decide which currencies to trade and how to handle volatile exchange rates. It should always be taken into consideration when choosing the position size, currency pair beside entry and exit points.
What is Volatility?
Volatility refers to the price fluctuations of an asset. It is typically measured by the difference between the opening and closing prices over a certain interval of time. It can also be defined by how quickly prices fall or rise.
Market volatility particularly measures how risky the investment is. The higher the volatility, the riskier a trade becomes and conversely when the volatility is lower.
To measure how volatile a price is, you have to assess fluctuations over a set period of time. For instance, if the exchange rate of a currency pair fluctuates quickly in a short time frame, then it is categorized as a highly volatile pair. On the other hand, if the rate moves slowly over a longer time frame, then it’s low volatile.
In the forex market, you can notice that some currency pairs or specific currencies are more volatile than the others. Currencies of emerging markets and exotic currency pairs, for example, are usually more volatile than major currency pairs or safe haven currencies.
Famous currencies of emerging markets in forex trading include the Turkish Lira, Indian Rupee and Mexican Peso. While safe haven currencies include the Japanese Yen and the Swiss Franc. Also, the US dollar can sometimes be traded as a safe haven currency.
What causes Price Volatility?
Market volatility is usually caused by economic factors, interest rate changes, sentiment and fiscal policy adjustments. More recently, political developments have been a leading factor. It often reflects levels of market sentiment, so any factor that can influence investor behavior will drive market volatility.
To consider a market as volatile, prices should fall or rise by more than 1% over a sustained period of time.
How to deal with a Volatile Market?
Generally, volatility does happen frequently and a successful trader should learn how to deal with them properly. It is possible to benefit from the market in any status, only if you know how. One strategy to deal with a volatile market is to start small, and to choose your trades wisely. Because volatile markets are unpredictable, it is important not to be overconfident, and to be willing to rapidly make changes when necessary. Leave the emotions out of your decisions, stay focused and track your trades.
Market Liquidity and Volatility
In simple terms, liquidity refers to how active the market is. It is how easily or quickly you can execute a trade. Typically, it is determined by the total active traders and total trading volumes.
High liquidity is one of the most common benefits of forex trading as it is accessible 24/5 with over $6 trillion dollars being traded on a daily basis.
The market’s liquidity has a big impact on how volatile prices are. The more liquid a market is, the lower volatile the price is. That’s why most forex traded pairs like the EURUSD normally do not experience high price fluctuations. On the other hand, exotic currency pairs fluctuate more often due to low liquidity.
Main Types of Volatility
There are several types that include:
Historical Volatility: It measures the historical price fluctuations, usually over the last 12 months. The asset is considered more volatile and riskier when the price is more deviated from its own average. However, this type normally does not provide insights about the future trend or direction of the price.
Implied Volatility: It is predicting the future prices by evaluating options prices variations. Rising option prices indicate increasing volatility, and vice versa. It is also known as future volatility.
Market Volatility: It is how fast prices change in a specific market, and is characterized by high levels of uncertainties.
How to Predict a Volatile Market?
Average True Range: This indicator calculates the true range of prices that are generated as a 14-day moving average. The true range is the highest value of one of the following three equations:
- True Range = Current day’s high – current day’s low
- True Range = Current day’s high – previous day’s close
- True Range = Previous day’s close – current day´s low
Bollinger Bands: It is a volatility tracking indicator that consists of two bands or lines that represent the standard deviations above and below the 20-day moving average. The bands widen with increased volatility and narrow with low volatility.
The Cboe Volatility Index (VIX): is an index that measures market’s expectations for volatility over the coming 30 days. It reflects market uncertainty, as reflected by the level of expected volatility. It is often referred to as the fear index.
Learn Forex Analysis and Start Trading Now
In Forex trading, market analysis plays an important role in setting up a successful trading strategy and increasing the profitability from the volatile market. In order to prepare for such risky trading conditions, it is important to learn forex fundamentals and guidelines.
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