Forex Volatility: Why is it important and how to measure it?

Everyone is familiar with the term ‘Volatility’ in the realm of Financial Trading. Forex Volatility is akin to the changing weather conditions where traders are the sailors navigating through the markets to execute trades by analyzing price fluctuations. This blog will explore the importance of understanding volatility, how to measure it, and will highlight some useful volatility indicators to assist in trading.

Table of Contents

What is Forex Volatility

Forex volatility is a statistical measure that calculates the rate at which the price changes in a financial instrument/pair. It is measured by taking into account the standard deviation of the price fluctuations over a given period of time for any instrument. It gauges the price swings in either direction (up or down). If a currency’s value experiences sharp and frequent movements in both upward and downward directions, it is considered to have high volatility. Conversely, if a currency pair has less significant price movements, it is considered to have low volatility.

If a financial instrument/pair has highly volatile price fluctuations, it is considered to be of high risk and vice versa. Some traders prefer to trade highly volatile currency pairs or trade during high-volatility trading hours as it brings more trade opportunities. However, it is important to remember that this also means higher risk, so it’s crucial to practice strict risk management to protect your capital.

high-low forex volatility

Importance of Understanding Volatility

Volatility and Liquidity for Forex Currency Pairs

By understanding the volatile nature of any financial instrument, traders are able to steer clear of overly risky trades or, even better, make well-timed entries for the potential of greater rewards.

The liquidity of a financial instrument provides insights into the expected volatility of that currency pair. Liquidity and volatility are inversely related in the Forex market. When considering specific currency pairs, higher liquidity corresponds to lower forex volatility. Conversely, less liquid pairs tend to be more volatile. Currency pairs fall into three categories: Majors, Minors, and Exotics. You can refer to the image below for a list of currency pairs categorized accordingly.

Liquidity image

Volatility by Trading Sessions

Forex Volatility creates price movements, and these fluctuations offer trading opportunities. Another factor to consider is the trading session or market hours when effectively managing market volatility. The Forex market has 4 major trading sessions and the volatility varies in each session. Furthermore, traders need to be cautious during High Impact News releases where the liquidity can dry up, and volatility can sharply increase which may result in experiencing high spread and slippage.

Different trading strategies are better suited to different volatility conditions. Later in this blog, we’ll explore several types of volatility indicators that help gauge market volatility and identify trade entries.

Below is an image demonstrating the nature of forex volatility in each trading session. As can be seen, the London and New York Overlap is one of the most volatile periods as both the London and New York sessions are active simultaneously.

Volatility by Trading Sessions image for blog

Volatility as a measure of risk

Understanding forex volatility is crucial for managing risk. Traders use volatility measures to set stop-loss and take-profit levels, as well as to determine position sizes. Highly volatile currency pairs tend to have more significant price fluctuations that might necessitate wider stop-loss orders to withstand price swings. Therefore, it plays a vital role in determining the appropriate placement of stop-loss orders.

Moreover, traders can use volatility measures to time their entries and exits. Lower-risk traders may prefer to enter the market during periods of lower volatility, while more risk-tolerant traders may seek opportunities during higher volatility.

Measures of Volatility

Historical Volatility vs Implied Volatility

Volatility is a significant factor to consider as it primarily assesses risk. Historic volatility can be used as a tool by traders who are trading only the underlying instrument. When volatility rises, so does the level of risk and uncertainty, and vice versa. It serves as a gauge of how far a price deviates from its average within a given timeframe.

A higher indicator value corresponds to more significant price swings. This indicator is commonly used to identify instruments with high volatility, which may indicate a potential shift in trends. It’s often used in conjunction with other signals and confluences for an added layer of confirmation.

Let us now have a look at a chart with historical volatility for easier understanding.

Note: It doesn’t provide any indication of the direction of price movements, only the extent of price volatility.

Historical Volatility vs Implied Volatility indicator

On the other hand, Implied volatility is not commonly used in the Forex market as it is in options and futures markets. In forex trading, traders primarily focus on historical volatility or price action to assess market conditions and make trading decisions.

Implied volatility is a concept associated with options trading, where it reflects the market’s expectation of potential price fluctuations in the underlying asset. For example, the Volatility Index – VIX is the primary measure of volatility in the stock market, particularly in the options market for the S&P 500 Index. It reflects market expectations and sentiment about future price fluctuations in the stock market.

Type of Volatility Indicator

The primary role of volatility indicators is to measure the degree of price fluctuations in a financial instrument that assists traders in assessing risk, identifying potential trade opportunities, setting appropriate stop-loss and take-profit levels for trades, gauging the strength of a trend, and signalling a potential reversal in the markets. Now, let’s explore and gain an understanding of one of these volatility indicators.

What is the Average True Range (ATR)?

The Average True Range indicator, developed by J. Welles Wilder, is used in financial markets to measure the volatility of price changes in any given instrument over a specified period.

As the name suggests, it is the average of the True Ranges (TR) over a given period. The standard parameter commonly used for that is 14. This means that it takes the average of the True Ranges of the last 14 candles, whichever timeframe the trader is analyzing. For instance, if the 4-hour timeframe chart is selected, it will show the average volatility of the last 14 4-hour candles. Likewise, if a 1-hour timeframe is chosen, it will display the average volatility for the last 14 hours i.e., 14 1-hour candles.

As we are aware, the market trends are in 3 major ways, it will either trend upwards, downward, or sideways. During uptrends and downtrends, with rapid price movements, ATR has a high corresponding value. Whereas, if the market is observed to be trending sideways (consolidation), ATR has a low corresponding value (measured in pips).

Common misconception: Higher ATR value does not indicate a Bullish market and vice versa. The indicator simply provides the degree of price volatility.

Before we jump on to read the ATR indicator on a chart, let us first learn how it is calculated.

How is the Average True Range (ATR) calculated?

First, let us look into how the True Ranges are calculated. Once we have the True Ranges, we can calculate ATR through the Simple Moving Average Formula (SMA).

True Range is the greatest value from the following:

·        The difference between the Current Period High and the Current Period Low

·        The difference  [Absolute] between the Current Period’s High and the Previous Period’s Close

·        The difference [Absolute] between the Current Period’s Low and the Previous Period’s Close

[Absolute]: Absolute value simply takes into account the difference and not the direction as it only measures volatility and not the trend direction.

Depending on the length of the period selected, ATR can then be calculated using the SMA formula as follows:

where n = The length of the period, standard parameters (7,14,20)

Relying solely on the volatility of the most recent day or hour often falls short in providing sufficient data for informed decision-making. Therefore, the ATR indicator calculates and displays the average volatility over a defined number of period (n)

Let us also give a quick look at visual representation for easier understanding:

true range image for blog

How is the Average True Range (ATR) indicator useful in Trading?

Normally, ATR is used by traders for the following 2 common trade opportunities:

  • Trend Reversal
  • Break-out of range

First, let’s take a look at how to read the ATR indicator on a chart, followed by an example of each scenario mentioned above. Below is the GBP/USD chart on a Daily timeframe:

Average True Range (ATR) indicator image for blog

As shown above, during a downtrend (marked as 1), ATR trends up sharply whereas, in an uptrend (marked as 3), ATR value slowly trends down. This is usually caused due to the element of fear in a downtrend. Picture it like this: markets move uphill like a hiker ascending a mountain trail, but they come crashing down like a skydiver plummeting from the sky.

On the other hand, we can notice that during a low volatility period (marked as 2), the price consolidates i.e., the price moves under a fixed range). Now, let’s delve right into identifying potential trade opportunities.

How to identify Trend Reversals using Average True Range (ATR)?

When the market is in a significant uptrend or downtrend, it’s natural to experience a sense of uncertainty regarding the continuation of that trend or the possibility of a reversal. This is where the Average True Range (ATR) comes into play. While market outcomes are never guaranteed, ATR helps traders seek higher probability scenarios to make informed decisions.

For a tangible grasp of the concept, let’s examine it within the context of the example shown below:

Trend Reversals using Average True Range blog for image

As we can see in the image above, when the value of ATR peaks, there is a higher probability of a trend change. It’s essential to emphasize that ATR is most effective when used in conjunction with other confirming factors, increasing the probability of making accurate trading decisions. There are numerous ways to have confluences, we looked at Support and Resistance levels at peaked ATR value for potential reversal confirmation. To learn more about Support and Resistance, you may refer to our blog {Title-Hyperlink}

How to identify Break-out trade opportunities using Average True Range (ATR)?

Traders often anticipate the occurrence of a breakout when the market undergoes a consolidation phase that extends over a specific duration. This consolidation phase is characterized by the trading instrument being confined within a defined price range, which can take the form of a rectangle or a triangle pattern. Throughout this consolidation period, market volatility tends to be relatively low. However, when the price eventually breaks through the established trading range, whether to the upside or downside, it frequently does so with a notable surge in volatility.

Hence, we will examine one of the examples that shows how the ATR indicator can effectively assist in identifying and executing breakout trade opportunities.

In order to Identify a potential break-out trade opportunity, a trader should examine the following factors:

  1. Check for the extended period of low volatility (Low ATR)

[Depending on the timeframe – A higher timeframe (Daily, Weekly) is ideal for directional bias]

  1. Identify the corresponding sideways (ranging) price action for the period of low volatility
  2. Identify the price break-out from the consolidation range with high volatility (High ATR)
  3. Look for potential trade entry preferably with another confluence

[another confluence could be any other tool, Indicator, Demand/ Supply zone, etc]

A visual example can help us grasp this better, so let us dive in:

Break-out trade opportunities blog for image

How can the Average True Range (ATR) be used to assist in placing a Stop-Loss?

The Average True Range (ATR) is a useful tool for determining the appropriate placement of a stop-loss in trading. This helps align your stop-loss with the volatility of the trading instrument.

The multiplier is a numeric factor that traders use to determine the distance for placing a stop-loss. The multiplier is applied to the ATR value to set the desired level of risk or volatility tolerance. There is no one-size-fits-all multiplier, as it depends on the trader’s risk appetite, market conditions, and trading strategy.

However, a rule of thumb is to set a stop-loss twice the size of ATR. It can also aid in Implementing a trailing stop-loss strategy to lock in profits as the trade moves in your favor. Illustrated below are examples for better clarity:

For a Sell/Short trade:

  • Identify the ATR for the candle of entry
  • Use a multiplier according to your risk and tolerance
  • In the example to your right, the ATR is 4.20. With a multiplier of 2, the stop-loss level becomes 8.20 above the closing price of the candle
  • With the close price of 1975 (marked as 1), the Stop-loss becomes 1975 + (2 x 4.20) = 1983.60
  • Likewise, the Stop-loss can be trailed using ATR accordingly (marked as 2), Stop-loss becomes 1970 + (2 x 3.60) = 1977.20
Sell/Short trade

For a Buy/Long trade:

  • Identify the ATR for the candle of entry
  • Use a multiplier according to your risk and tolerance
  • In the example to your left, the ATR is 1.80. With a multiplier of 2, the stop-loss level becomes 3.60 below the closing price of the candle
  • With the close price of 1970 (marked as 1), Stop-loss becomes 1975 – (2 x 1.80) = 1966.40
  • Likewise, the Stop-loss can be trailed using ATR accordingly (marked as 2), Stop-loss becomes 1975 – (2 x 3.10) = 1968.80
Buy/Long trade blog image

To Conclude

This blog detailed the importance of recognizing volatility, its measurement, and practical applications. Key concepts included the relationship between volatility and liquidity, the influence of trading sessions on volatility, and the use of volatility measures. Additionally, the Average True Range (ATR) indicator’s role in identifying trade opportunities, setting stop-losses, and understanding market trends was highlighted. Overall, grasping volatility is crucial for informed trading strategies and risk management.