What is a Forex Volatility?
The rate at which market prices fluctuate is known as its volatility. The volatility of market prices is strongly influenced by the market’s liquidity. When there is less money in the market, prices tend to fluctuate wildly. When there is more money in the market, prices don’t tend to change as much.
Since higher liquidity translates in lower volatility, liquid markets like forex tend to move in smaller increments. When there are many of buyers and sellers at the same time, prices tend to fluctuate slightly. The foreign exchange market can see rapid and unexpected shifts, though. There are various factors that contribute to currency price fluctuations, including political, economic, and social events. Traders who are aware of the market and the news can uncover opportunities for profit and mitigate risks. To help you better understand Forex Volatility, we have compiled this definitive guide.
What is volatility in Forex trading?
Currency price volatility is a key indicator in the foreign exchange market. Trading a currency with a high volatility level in the Forex market carries a higher risk. Trading extremely volatile currency pairs, however, opens you up to the possibility of massive profits. The volatility of the most traded currency pairings is lowest, while that of the more exotic ones is highest.
What causes volatility in Forex?
Given the current state of the global markets, the nature of interconnected trades, the ease of information and communication, and the widespread use of social media and digital technology, market experts agree that market volatility is at the forefront of every trader’s mind. Some factors to keep in mind are:
Interest rate changes
When interest rates shift, so does the volatility of the foreign exchange market. If the interest rate of an economy rises, investors will be less likely to put money into it. This would lead to a sharp decline in the value of the domestic currency and increased volatility in the foreign exchange market.
The world’s central banks play a crucial role in regulating the global monetary system. By controlling interest rates, they can manage the supply of money. Forex traders all across the world, from the United States’ Federal Reserve to Europe’s ECB, Britain’s BoE, Japan’s BoJ, Canada’s BoC, and Australia’s ARB, keep a close eye on policy moves made by their respective central banks.
Similarly, a decrease in the interest rate would encourage consumers to spend more now that they have more disposable income, which in turn would cause an increase in the value of the domestic currency on the market.
Economic shocks affecting supply and demand
Foreign exchange volatility can also be negatively impacted by domestic shocks such as a shift in taxation policy or a sharp increase in energy costs. For instance, if a country imposes significant taxes on commerce, severely affecting a large portion of the consumers, fewer people would participate in the Forex market, causing currency pair values to fall and volatility to increase.
Trade conflicts, whether they involve the United States and China, the United States and Europe, or any other area or country, can increase market volatility because of the enormous volume of money changing hands. The currencies at stake in a trade war are bound to be impacted in some way.
In a similar vein, if domestic oil prices rise due to excessive demand, this may cause a rise in the value of the currencies of Gulf States, as these nations will be able to supply more oil and earn more money as a result. This would again cause significant fluctuations in the value of international currencies traded on the Forex market.
Global changes and events
The volatility of the Forex market can be significantly impacted by a number of worldwide changes and events, including political elections, natural catastrophes, wars, and similar occurrences. A government change is seen as a change in the political attitudes of the nation, which can create volatility to the market, thus most traders would avoid investing in the currency of a country that is about to hold elections.
Trader and market sentiment
Market movements are driven by the people behind them. Traders and investors around the world make markets move. And depending on the prevailing sentiment, whether positive or negative, market volatility can fluctuate.
How to identify currency volatility?
Due to its inherent unpredictability, currency volatility is notoriously difficult to detect and monitor. However, there are ways to quantify volatility that might aid investors in making informed predictions.
It is important to include both historical volatility and implied volatility for a precise assessment. Volatility has always existed, but the price of futures options reflects traders’ predictions for the future, which is represented as implied volatility.
Volatility over time can be viewed in charts, where the peaks and valleys in prices are readily apparent. Traders can use the four CBOE indexes that track market expectations of currency volatility for calculating implied volatility.
What are some of the most volatile currency pairs?
There are some currency pairs that are more volatile than others.
Many investors use the AUD/JPY exchange rate as a gauge of risk. If risk appetite is strong, investors will be interested in purchasing the Australian dollar. However, when markets are in a “risk-off” posture, the Japanese yen, a traditional safe haven, will attract buyers. This makes the AUD/JPY a highly speculative pair of currencies, as its value will rise when investors are feeling risk-seeking and will fall when they are becoming more risk-averse.
The exchange rate between the British pound and the other major currencies is typically the most volatile. As a major oil producer, the Canadian Dollar, like the Australian Dollar, is a “risk-on” currency that follows the movement of the oil price closely. The Canadian dollar could be severely impacted if markets go into “risk-off” mode at the same time that oil prices are declining. The opposite is true: the currency does well when both commodity prices and the appetite for risk are high.
Geopolitical factors, as well as the volatility of the Turkish Lira’s central bank and the impact of politics, contribute to the currency’s unpredictable trajectory.
Forex market volatility trading tips
Knowing the inherent nature of volatility and the factors behind it, how can you use it in your favour? How can you harness volatility in your forex trading? Some tips are as follows:
Trade Using Charts and Indicators
Various technical indicators can be used to gauge market sentiment and forecast future price movement. Charts and indicators, while not conclusive, will aid you in developing a trading strategy and determining entry and exit points.
Use stop loss orders
Stop losses are useful in any trading situation, but they take on added significance when dealing with volatile currencies. Stop losses allow you to plan ahead for lost transactions and limit your potential losses to an amount that is comfortable for you. If you trade with leverage, you stand a significantly greater risk of losing more money than you initially deposit, making this a must-read.
Monitor the economic calendar
You can predict market volatility to some extent if you keep an eye on the economic calendar and familiarise yourself with the important economic events and choices that have the potential to affect the markets. Remember that volatility is inherent to the markets. The test for you as a trader is how you respond to it.
When there are significant events that could increase volatility, some investors choose to take a pass. However, there are other market participants that want to profit from the price fluctuations that accompany such landmark occasions. No matter your trading style, it pays to stay on top of the most important developments. To keep up with these big events, it is important to learn how to read the economic calendar.
Keep Position Size Low
In the highly volatile forex market, both large gains and losses are possible. Any trader dealing with volatility would be wise to keep their position size small. Keep your open deals to no more than 5% of your trading capital. Your location will have greater leeway to manoeuvre, and your resources won’t be depleted as quickly.
Limit your leverage
By now, you should realise that leverage can work both ways. Both your successes and failures may be amplified. Reducing the leverage on your transactions is an early step in the direction of risk management.
Keep A Trading Journal
Keeping a trading journal to record your transactions is a highly recommended practise. It’s especially helpful when dealing with the unpredictable forex market, as you can review your past trades and determine what worked and what didn’t. You may develop as a trader by constantly evaluating, reflecting, and improving the way you trade with the help of a well-kept trading notebook.
The difference between volatility and risk
There are variations between volatility and risk. For risk, you can select how much you can handle, but volatility is out of your control. However, their bond is strong. Trading volatile currencies is risky since prices can change suddenly. This big fluctuation magnifies gains and losses.
Forex traders often take a risk on a volatile market because others are doing so. Traders may sell low during a market meltdown, risking large losses. You must constantly consider risks and advantages and drawbacks before trading, especially in unpredictable markets. Never trade based on popular opinion; utilise your own risk management approach to trade with a risk you can afford.
Pros and Cons of Forex Volatility
Enhances leverage improves capital efficiency
Not easy trading
Dependent on news
Understanding volatility is crucial for success in the financial markets. Investors may use the term without fully grasping its significance or the mechanics of the ever-changing financial markets. Because of the high stakes involved in trading in volatile markets, it is crucial to manage your risk effectively and conduct extensive due diligence before making any trades.
Many traders’ careers are cut tragically short due to poor risk management. It’s important to know when to enter and stop a trade to maximise profits. Investors who want to maximise their returns while minimising their exposure to risk generally select lower-volatility portfolios.
A trader’s perspective on volatility is heavily influenced by his or her risk tolerance. It is essential to constantly monitor and study market trends in foreign exchange, as volatility can either increase profit potential or inflict avoidable losses. This is especially important during political and economic uncertainty, which can have a significant impact on the foreign exchange markets.