If you are looking at a currency pair on a price chart, you will notice that prices will move up and down at varying rates and this is the volatility of the pair. Understanding the volatility of currencies is vital if you want to trade them successfully. Here we will give you an introduction to understanding Forex volatility and its impact on price.
Any currency trader needs to understand volatility in order to place trading signals with the best risk to reward and changes in volatility, also will help you spot profit opportunities shaping up in the pair you are trading. If you want to learn technical analysis and have a technical strategy which makes money, you must understand the impact of volatility on price so let's take a look at it in more detail.
Forex Volatility Defined.
Volatility is a statistical measure of the dispersion of returns for a currency. Volatility is typically shown by standard deviation or variance from a mean of the particular currency pair you are looking at.
In simple terms volatility refers to the amount of uncertainty or risk in the terms of the size of price change in any currency pair. A higher volatility means is considered more risky than a pair which has a lower volatility when the pair does not fluctuate so much and changes in the value of the pair changes at a slower rate over a period of time.
Points to Keep Mind with Your Trading Strategy
The first point to keep in mind is when you place a trade in the market, you need to place it outside of the random volatility of the pair you are trading but most traders never learn this lesson. They will trade currency pairs which move 100 pips in a day and try and scalp some pips in time periods of minutes or hours. What they don't understand is that all volatility in daily periods can be random and always has been. The important point to keep in mind is to use daily support and resistance levels, to time your trading signals and use them, for market timing rather than using levels within the day.
Your top will be further away from the entry point of your trading signal but in volatile markets, you have to take a sensible defined risk, to make a reasonable reward and Forex markets are a risk market. If you try and cut risk back to much, you will end up not being able to make a profit.
Volatility of Any Currency Pair Varies
Markets can be restricted in price ranges which are tight and when this happens volatility tends to be low. When you have low volatility and it changes to high volatility and a break from the range occurs – a new trend could be developing and you can look to get in on it. If very low volatility changes to high volatility it normally means, you are going to get a good trading signal.
High Volatility and Trends
Normally strongly trending markets have high volatility, as people get in on the trend and power it forward and you get a deviation from the mean price. While the price can move away from the mean strongly, it will eventually return to an average price. Deviation from the mean is to a large degree dictated by the participants when greed or fear are driving prices but this will subside.
Extreme Volatility and Blow Off Highs and Lows
When you get extreme price volatility, with large price ranges, human emotion is on control and this will result in a “blow off” high or low. Extreme volatility is normally a climax of greed or fear and means a good correction back to the mean price will occur or even a long term trend change.
One of the most popular ways to measure the volatility of a currency pair is to use Bollinger Bands which have a mean price which is a 20 day MA and an upper and lower band to show the deviation from the mean. In pure simple terms, the wider the bands are apart the high the volatility is at the particular moment in time.
Majors v Crosses
The major currency pairs which are traded through the USD, tend to be volatile and the two most heavily traded contracts are the USD against the dollar are – the Euro and Japanese Yen. While they will have shifts in terms of volatility over time, there daily ranges tend to be quiet wide and at times they are extremely volatile. The huge amount of people trading these pairs, means high speculative interest and these speculators contribute to volatility and the creation of price spikes.
At many times the cross rates through the dollar, will provide trends with less volatility and these can be great markets to trend as when trading them, you are likely to be taken out by price spikes, as speculative interest is lower.
The above is a short summary of volatility, in relation to the Forex markets and you need to understand its impact on prices, to win with your currency trading strategy. Most traders don't think about its impact on their technical analysis or harness it, to help them make money but if you do, you will be able to make some great trading profits.