Currency Volatility: What is it & How to Trade It?
Currency volatility is characterized by frequent and rapid changes to exchange rates in the forex market. Understanding forex volatility can help you decide which currencies to trade and how. In this article, we explore what FX volatility is and how to identify it, reveal the high volatility currency pairs to look out for, and disclose the strategies to employ for consistent forex volatility trading.
What is Volatility in Currency Trading?
Volatility in forex trading is a measure of the frequency and extent of changes in a currency’s value. A currency might be described as having high volatility or low volatility depending on how far its value deviates from the average – volatility is a measure of standard deviation. More volatility means more trading risk, but also more opportunity for traders as the price moves are larger.
Below is a chart comparing Bitcoin/US Dollar and New Zealand Dollar/US Dollar, with the orange line for each showing the Average True Range (ATR), a common measure of volatility. As the ATR values for each asset demonstrate, NZD/USD is a stable currency pair, and BTC/USD is much more volatile.
How to Identify Currency Volatility
Currency volatility is difficult to identify and track because volatility is, by its very nature, unpredictable. But there are some methods of measuring volatility that can help traders predict what might happen.
There are also two types of volatility that need to be addressed for an accurate measure – historical volatility and implied volatility. Historical volatility has already happened, and implied volatility is a measure of traders’ expectations for the future (based on the price of futures options).
You can view historical volatility in charts, where you can clearly see spikes and troughs in prices. For implied volatility, traders can use the four CBOE indices that measure the market’s expectations in relation to currency volatility.
Trading High Volatility Currencies vs Stable Currencies
With some of the most volatile currency pairs, traders should expect frequent fluctuations. Major currency pairs tend to be more stable than emerging market currency pairs; the more liquid currency pairs tend to have less volatility. Some of the most volatile currency pairs are:
- USD/ZAR (United States Dollar/South African Rand)
- USD/RUB (United States Dollar/Russian Ruble)
- USD/BRL (United States Dollar/Brazilian Real)
- USD/TRY (United States Dollar/Turkish Lira).
AUD/JPY is another pair that has historically been considered volatile. The below chart shows the asset's price movement, again alongside ATR. The circled portion is just one example of where ATR hit new heights as the AUD/JPY rate fell rapidly.
Examples of currencies traditionally seen as having low volatility are:
- EUR/GBP (Euro/Pound Sterling)
- NZD/USD (New Zealand Dollar/United States Dollar)
- USD/CHF (United States Dollar/Swiss Franc)
- EUR/USD (Euro/United States Dollar).
You might use different indicators when trading high and low volatility currencies. For lower volatility currencies, you can look to use support and resistance levels. These show where the forex market has moved up and pulled back again, so they can be used to trade by helping you predict the market’s movements. You can set your stop loss at a level you are comfortable with to ensure your losses don’t mount up.
This may be more difficult to do with volatile currencies as their price changes can be erratic. These are some of the indicators you can use to trade them:
- Bollinger Bands: These can be used to indicate if a market is overbought or oversold, increasing the chance of prices beginning to move in the opposite direction
- Average True Range: This is used as a measure of volatility, and it can be applied to trade exit methods with a trailing stop to limit losses
- Relative Strength Index: You can use this to measure the magnitude of price changes, again indicating whether a currency has been overbought or oversold so you can decide on your position.
Knowing the Difference Between Volatility and Risk
There are some distinct differences between volatility and risk. Volatility is out of your control, whereas risk is not; with the latter, you can decide exactly how much you are willing and able to manage. However, the relationship between the two is strong. Trading volatile currencies always carries risk because prices could move sharply in any direction, at any time. This large swing can magnify losses as well as gains.
One common pattern that emerges in forex trading involves a degree of herd mentality – traders decide to take a chance on a volatile market, largely influenced by the fact that other traders are taking the same action. In the event of a market crash, traders may sell at a lower price, potentially incurring big losses. You always need to be fully aware of risks and weigh up the pros and cons of any trade, especially when a market is volatile. Never take a risk based on popular opinion and use your own judgment, employing your personal risk management strategy to make sure you trade with a level of risk you can afford.
Forex Volatility Trading Tips
There are some specific forex volatility trading strategies and tips you can use. These will help you to make the most of your trades but, importantly, they will also help you minimize risk so you can protect yourself against heavy losses. Volatile markets are always risky, so one of the most important things you can do is have a strategy in place and stick to it.
Forex volatility trading tips:
- Trade using charts and indicators
- Trade around news and events
- Use stop losses
- Keep position size low
- Adhere to your forex trading strategy
- Keep a trading journal
Trade Using Charts and Indicators
As covered above, there are various technical indicators you can use to anticipate market sentiment and make predictions about future price direction. While not definitive, using charts and indicators will help you formulate your strategy and choose when to trade.
Trade Around News and Events
Following news and current affairs can alert you to events that might have an economic impact and affect the value of currency. Currency volatility will often coincide with political or economic turbulence, so a general awareness of news releases can be followed from the DailyFX economic calendar. Trading around news events is one way to sidestep volatile conditions.
Use Stop Losses
It is always good practice to use stop losses to minimize risk when trading and this becomes even more important when you are trading volatile currencies. Your stop losses will ensure that any losing trades can be accounted for beforehand and you can select a level of loss that is affordable for you in the worst-case scenario. This is especially important if you are trading with leverage, as your losses could be significant, and you could lose much more than you deposit.
Keep Position Size Low
There is the potential for big wins in volatile forex markets, but there is also the potential for big losses. Keeping your position size low is a prudent decision for any volatility trader. It’s advisable to ensure you risk no more than 5% of your account on open trades. This will give your position more room to move without rapidly depleting your funds.
Adhere to Your Forex Trading Strategy
Make sure you have a trading plan, and stick to it. Following your trading plan closely will help you to manage the swings of volatile markets.
Using the tips outlined in this piece and following your trading plan closely will help you navigate volatile markets and trade more consistently.
Keep A Trading Journal
Using a trading journal to keep a log of your trades is a very good habit to adopt. It’s especially valuable when you’re trading volatile forex markets, enabling you to look back on your trades so you can consider what worked and what you could have done differently. A well-maintained trading journal will help you to become a better trader through the continual process of self-evaluation, reflection and improvement.
Further Reading on Volatility
DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.