In financial markets, prices are always moving. This is good since you can’t make money as a trader if prices don’t change. Volatility is the speed or degree of price change (in either direction). As volatility rises, so does the potential to make more money quickly. Higher volatility indicates higher risk.
When volatility spikes, you may be able to generate above-average profits, but you also risk losing a larger amount of capital in a shorter time. If you’re disciplined, you might be able to profit from volatility while minimising risks.
In this article, I will share what volatility is, how it works and how important it is in trading forex.
Volatility is a measure used to gauge how drastically prices change in a market. How volatile a market’s prices depend significantly on how liquid the market is. Higher liquidity typically provides a less volatile market where prices don’t fluctuate dramatically; lower liquidity typically leads to a more volatile market where prices change dramatically.
Because of their high liquidity and low volatility, liquid markets like the forex usually move slowly. The price typically moves somewhat up and down when several traders are trading.
For instance, a currency pair that fluctuates between 5 and 10 pips is less volatile than one that oscillates between 50 and 100 pips.
If you look closely, you may notice that some currencies and currency pairs are more volatile than others. You’ve probably heard of the term “safe haven currency,” which refers to currencies like the U.S. dollar, Swiss franc, and Japanese yen (to a certain degree).
On the other hand, emerging market and exotic currency pairs like the Turkish Lira, Mexican Peso, Indian Rupee, and Thai Baht are more volatile than safe haven currencies.
It would be best if you always choose a currency pair that suits your trading style and preferences. While some traders like the high risk of volatile markets, others might not.
However, the forex market also faces volatility when it encounters sudden and drastic movements. Since there are so many political, economic, and social events that have an impact on currencies, many different things can cause prices to fluctuate. To uncover potential profit and better avoid loss, traders should be mindful of current events and keep up to date on financial news.
In one way, the forex market is volatile due to the increased liquidity in exotic cross-currency pairs. Volatility here refers to either the frequency or strength of price changes.
If we take the Japanese Yen or the Euro, these currencies are commonly used in trading, or to put it another way; it involves significant buying and selling. As a result, their prices change nearly frequently within a given time.
However, the base and quote currencies in a pair determine the currency’s volatility rate. The currencies with lower participants in the forex market are referred to as exotic cross-currencies. As a result, it is also the riskiest cross-currency trading.
Cross-currency pairs are currencies that are directly traded with one another in the forex market. One may now directly convert money into another desired currency through cross-exchange transactions.
You can directly exchange Euros for yen without linking the conversion to U.S. dollars. Cross-currency pairs are increasingly being used for transactions as the forex market expands.
However, these are recognised as being volatile. For instance, a cross-currency pair is regarded as volatile in the forex market if its rates change to 0.7% in a standard period.
Minor cross-currency pairs are the ones that do require conversion into some of the other major world currencies but exclude conversion into the U.S. dollar.
Euro, Yen, Pound, Swiss Franc, or New Zealand/Australian Dollar, to mention a few, must all be included in the pair, either singly or in pairs. Such as EUR/GBP, CAD/GBP, CHF/GBP, etc. They are less volatile.
These currency pairs only comprise exchanges where recent transactions have occurred. Comparable to EUR/USD, USD/JPY, or USD/CHF. Transactions involving U.S. dollars are included. Most importantly, these significant currency pairs are the most actively traded and the most secure for transactions.
In contrast to other currencies subject to the same market conditions, the U.S. dollar and Swiss franc have a direct relationship, as seen by comparing USD to CHF. Because both currencies have a positive correlation, it demonstrates that major pairs have less volatile readings.
Exotic currency comprises pairs of the most frequently dealt with and most recently evolving currencies. For instance, it includes pairs like USD/TRY and USD/MXN.
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You must first understand what liquidity is to know how market liquidity and volatility are related.
A market’s liquidity measure indicates how quickly and easily you may buy or sell a product. A market participant must be willing to sell you 100 ounces of gold if you want to purchase it.
This is not an issue in highly liquid instruments. During the London market session, you may execute a EUR/USD trade of 10 million without encountering difficulties or moving the market. However, timing is crucial since there’s a chance that certain sessions would have lower currency liquidity.
For instance, you could find that the liquidity is not so great if you decide to execute that EUR/USD trade between the end of U.S. trading and before the Tokyo opening. As a result, you can have a worse execution than anticipated.
In general, the lower the volatility, as it takes much more to move an instrument in a particular direction, the more liquid the trading instrument is. It would require a massive transaction to significantly move the U.S. bond market or the EUR/USD currency pair in one direction.
A currency from an emerging market, such as the South African Rand or the Mexican Peso, might be moved with a lot less effort. For that particular reason, such currencies tend to be more volatile.
Risk and volatility have some definite differences. Risk, however, is something you can control; you can choose how much of it you are willing and able to manage with the latter. Volatility is something you cannot control. The relationship between the two is strong, though.
Trading volatile currencies always carry risk since prices might move sharply at any time and in any direction. This significant swing may amplify both gains and losses.
One recurring pattern in forex trading is a degree of herd mentality, when traders choose to take a chance on a volatile market, often under the influence of other traders who are doing similarly. In a market crash, traders could sell their assets at a lower price, potentially incurring big losses.
When a market is volatile, you should always be fully aware of the risks and weigh the pros and cons of each trade. Use your judgment and your risk management strategy to ensure you trade at a level of risk you can afford. Never take a risk because it is the consensus.
The range of price movement, regardless of what you name it (uncertainty, volatility, fluctuations, etc.), is essential to trading the markets.
There are no price movements when there is no volatility. Furthermore, trading activity won’t be impossible without price movement.
The critical thing to remember is that for markets to function well, there must be some degree of volatility. But when volatility becomes too high, traders have a challenge.
As a forex trader, you must know which currencies are more volatile than others and when volatility is rising.
Market experts concur that market volatility is more on every trader’s mind these days than at any previous time due to the nature of the current global markets—interconnected trades, seamless flow of information and communication, and the prevalence of social media and digital technology.
Let’s examine some of the causes of volatility that may impact your forex trading.
One of the primary causes of volatility is wars (military invasion), uprisings, riots, and other types of civil unrest. This is because while some volatility is necessary for the markets, prolonged and intense levels of uncertainty (such as those caused by wars and uprisings) are bad for traders’ moods and the market as a whole.
Trade wars may cause market volatility because of the billions or trillions of transactions involved, whether they are between the U.S. and China, the U.S. and Europe, or any other region or nation. The currencies involved in a trade war will eventually be impacted, one way or another.
Global central banks play a significant part in controlling the flow of money. Adjusting interest rate levels may regulate the amount of money in circulation. Understandably, every forex trader monitors central bank decisions, whether they come from the U.S. Federal Reserve, the European Central Bank, the Bank of England, the Bank of Japan, the Bank of Canada, or the Australian Reserve Bank (ARB).
Market movements are, in fact, driven by the individuals who are behind them. Markets are driven by traders and investors all across the world. Market volatility can fluctuate depending on whether a positive or negative sentiment is prevailing.
Currency exchange rates fluctuate as a result of changes in market inflation. The value of a nation’s currency will rise if its inflation rate is lower than that of another. Where inflation is low, prices of goods and services rise more slowly. While a nation with higher inflation typically experiences currency depreciation and higher interest rates, a nation with consistently lower inflation typically sees rising currency values.
How do interest rates affect money exchange rates? Interest rate changes affect currency value and the dollar exchange rate. Correlations exist among forex exchange rates, interest rates, and inflation. A country’s currency gains value in response to increases in interest rates because higher interest rates provide lenders with higher rates, which draws in more foreign capital and raises exchange rates.Forex chart patterns - Chart visualisation to a tee — 2023
The balance of trade and income from foreign investments are both reflected in a country’s current account. It comprises the overall volume of transactions, such as debt, exports, and imports.
Depreciation results from a current account deficit, which causes when a country spends more of its currency on buying goods than it does on selling its exports. The local currency’s exchange rate fluctuates due to the balance of payments.
Government debt is any debt that the central or state governments possess. Government debt decreases a country’s ability to attract foreign capital, which increases inflation. Foreign investors will sell their bonds on the open market if the market anticipates government debt in a particular country. The value of its exchange rate will therefore decline.
Exchange rates can also fluctuate as a result of a trade deficit. The ratio of export prices to import prices is known as the terms of trade and is related to current accounts and balance of payments. If a country’s export price increases faster than its import price increases, its terms of trade improve.
Higher demand for a certain currency and an increase in its value are the results of this, which causes higher revenue. As a result, the exchange rate increases.
A state’s political climate and economic performance may affect its currency’s strength. Foreign investment attracts nations with lower political instability because they are more appealing to outsiders, displacing capital from nations with greater political and economic stability.
An increase in foreign capital, in turn, leads the value of the country’s domestic currency to increase. A nation with sound financial and trade policies does not allow for any currency value uncertainty. However, a nation prone to political turbulence can experience a decline in exchange rates.
Interest rates are likely to drop in a recession, making it harder for the nation to attract foreign investment. As a result, its currency’s value drops compared to other nations, lowering the exchange rate.
Investors will seek out more of a currency whose value is anticipated to increase to profit soon. The increase in demand will rise the currency’s value to increase as result. The exchange rate also increases with this rise in currency value.
The forex market is very volatile for a variety of reasons. The forex market, and individual currency pairs, in particular, are impacted by various macroeconomic and political factors. For instance, there is a lot of volatility in the forex market due to recent news about inflation and interest rate hikes.
Fundamental analysis in forex has a lot to do with understanding volatility. Without these price movements in profits, we would be unable to make from trading. This volatility is what leads to these price changes. Therefore, the forex market should have enough volatility for profitable trading.
Typically, the U.S. forex market is most active immediately following the opening of the New York session at 8 am (EST). As traders start opening and closing positions based on the morning’s market news, liquidity and volatility are likely to be high at this time.