Forex volatility: What is market volatility in forex?

Education / 5 Min Read
Milan Cutkovic / 05 Aug 2021

Warren Buffett was once quoted as saying: “Look at market fluctuations (volatility) as your friend rather than your enemy.”

While he was talking about markets in general, Buffett who is also known as the Sage of Omaha, could well be talking about volatility in the forex markets. Market fluctuations can indeed be your friend when forex trading online in the global market. But you have to know how to harness it and make it work in your favour.

What is volatility in forex trading?

In simple terms, volatility refers to the price fluctuations of assets. It measures the difference between the opening and closing prices over a certain period of time.

For example, a currency pair that is fluctuating between 5-10 pips is less volatile than a forex pair that fluctuates between 50-100 pips.

If you look closely you can see that some currencies and currency pairs are more volatile than others. You must have heard of the term ‘safe haven’ which refers to some currencies like the Japanese Yen, the Swiss Franc and the US dollar (to a certain degree).

On the other hand, emerging market and exotic currency pairs such as the Turkish Lira, Mexican Peso, Indian Rupee and Thai Baht are considered more volatile than the safe haven currencies.

So, depending on your trading style, strategy and trading preferences, you can always find a currency pair that will suit your trading technique. While some traders prefer volatile markets, others might not like the high risk that comes with high volatility.

Candlestick chart fluctuations

How are market liquidity and volatility related?

To understand the relationship between market liquidity and volatility, you first need to understand what liquidity is.

What is liquidity?

Liquidity is a measure of how quickly/easily you can buy or sell something in the market. If you wish to buy 100 ounces of Gold, there must be a market participant who is willing to sell this amount of Gold to you. 

In highly liquid instruments, this is not an issue. You could execute a EUR/USD trade worth 10 Million during the London market session without any difficulties and without moving the market. Timing is important though, as currencies might be less liquid during specific sessions.

For example, if you decided to execute that EUR/USD trade between the close of U.S trading and prior to the Tokyo opening, you might find that the liquidity is not that great and you could end up with a worse execution than you anticipated.

Generally speaking, the more liquid a trading instrument is, the lower the volatility, as it takes much more to move it in a certain direction. To significantly move the US bond market or the EUR/USD currency pair in one direction, it would take a massive transaction. 

On the other hand, it would take much less effort to move one of the emerging market currencies - such as the Mexican Peso or South African Rand. Those currencies tend to be more volatile for that particular reason.

Why is volatility important in the markets?

Quoting Warren Buffett again, he said: “All time is uncertain. It was uncertain back in 2007, we just didn't know it was uncertain.”

The fact is uncertainty, volatility, fluctuations or whatever you call the range of price movement – they are all intrinsic parts of trading the markets.

No volatility means there are no price movements. And without price movement it will be impossible to have any trading activity.

The thing to keep in mind is that a certain level of volatility is needed for markets to operate efficiently. The challenge for traders though is when volatility becomes too high.

As a forex trader, you need to be aware of which currencies are more volatile than others and when volatility is rising.

Further reading: Forex trading for beginners

What causes market volatility of currency pairs?

Given the nature of the current global markets – interconnected trades, seamless flow of information and communication and the prevalence of social media and digital technology – market pundits agree that market volatility is very much in every trader’s mind these days more than in any other period of time.

Let’s look at some of the factors that cause volatility that can affect your forex trading.

Geopolitical factors

Wars (military invasion), uprisings, riots and other forms of civil unrest count as one of the major causes of volatility. This is because while a certain level of volatility is needed in the markets, a prolonged and high level of uncertainty (in the case of wars and uprisings) is not good for traders’ sentiment and the market in general.

Trade wars

Whether it’s the US vs China, US vs Europe or any other region or country, trade wars can also spur volatility in the markets due to the billions or trillions of transactions involved. One way or another, the currencies involved in any trade war will be affected at some stage.

Monetary policies

Central banks across the globe play an important role in managing the flow of money. They can regulate the amount of money in circulation via interest rate levels. It’s no wonder that every forex trader is keeping an eye on central bank decisions – whether it is the US Federal Reserve, the European Central Bank (ECB), Bank of England (BoE), Bank of Japan (BoJ), Bank of Canada (BoC) or the Australian Reserve Bank (ARB).

Trader and market sentiment

It is a fact that market movements are driven by the people behind them. Traders and investors around the world make markets move. And depending on the prevailing sentiment – positive or negative – market volatility can fluctuate.

What are some of the most volatile currency pairs?

There are some currency pairs that are more volatile than others. Check out some of the most volatile currency pairs below and find out what makes them see larger fluctuations.

AUD/JPY

The AUD/JPY currency pair is seen as a risk barometer. The Australian Dollar is seen as a risk-on currency, meaning it will be in demand when risk appetite is high. On the other hand, the Japanese Yen is a traditional safe-haven and will catch a bid during times when the markets are in a "risk-off" mode. This makes AUD/JPY a volatile currency pair - i.e. it will rise when traders are feeling optimistic and seeking risk and fall when traders are turning risk-averse.

GBP/CAD

The British Pound cross rates tend to be the most volatile ones amongst the major currencies. The Canadian Dollar is another "risk-on" currency and is heavily influenced by the direction of the oil price, as Canada is a major oil producer. If markets move into "risk-off" mode and at the same time, oil prices are falling, the Canadian Dollar could come under significant pressure. On the other hand, the currency tends to thrive during times when traders are seeking risk and commodity prices are rising as well.

USD/TRY

The Turkish Lira can see significant price swings at times, which are driven by geopolitics but also due to the unpredictability of the country's central bank and influence of politics on its course.

Forex 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?

If you heed Warren Buffett’s word and look at market volatility as your friend rather than an enemy, there must be ways to make it work for you and your trading success.

Use stop loss orders: If you set a stop loss level for every forex trade you take, you are giving yourself extra protection for any market volatility.

Monitor the economic calendar: If you monitor the economic calendar and know the major economic events and decisions that can possibly move the markets, you will be in a better position to anticipate volatility, at least to a certain extent. Remember that volatility is part and parcel of the markets, the challenge for you as a trader is how you react to that volatility when it comes. 

Some traders prefer to stay on the sidelines when there are high-impact events that may push volatility higher. But there are also some traders who want to take advantage of the price movements around those major events. No matter what is your preference, it pays to monitor and keep track of key events that can impact your trading. Learn more about how to read the economic calendar to stay up to date on these major events.

Limit your leverage: You must be aware by now that leverage can be a double-edged sword. It can magnify your wins as well as your losses. By limiting the amount of leverage you use for your trades, you are already putting some risk management strategies in place.

What volatility indicators to use?

There are a number of technical indicators that are suited to analysing volatility in the market. Find some of the most common volatility indicators below:

Average True Range: The average true range indicator was developed by J. Welles Wilder Junior. The ATR calculates a "true range" and displays it as a 14-day exponential moving average of that particular range. The true range is the highest value of one of the following three equations:

  • TR = Current day´s high - current day´s low
  • TR = Current day´s high - previous day´s close
  • TR = Previous day´s close - current day´s low

A higher ATR reading indicates higher volatility.

Bollinger Bands: Bollinger bands were developed by John Bollinger. This volatility indicator shows whether prices are high or low on a relative basis. Bollinger bands consist of three lines - the lower, middle and upper band. The middle band is simply a moving average. The upper and lower bands are positioned on either side of the MA, and are calculated as 2 standard deviations above/below the MA.

A narrowing of the bands indicates low volatility, while a widening hints at increased volatility.

Conclusion

Volatility is one of the most important concepts to know when trading the financial markets. It's also a term that may be tossed around by investors without understanding what it means and how volatile markets actually work. By reading this article, you now know exactly how volatility works and how to trade it successfully!

Have you started trading volatile markets yet?

 

 

 

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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