Forex trading is done to make profits from the changing prices of currency pairs as we buy or sell a trading instrument based on the price fluctuation that is about to happen. The prices of forex pairs are based on exchange rates or in other words, they represent the value of one currency in comparison to another currency that is paired with it.
Since different currencies have different values, pips (percentage in price) are used for measuring and expressing price movements, A pip is the smallest whole unit price move that an exchange rate can make, based on forex market convention.
When it comes to calculating the monetary value of a pip in any currency, then it can be done with the help of a pip calculator. One key factor to consider for anticipating the price fluctuations of a currency pair is its volatility.
New traders might be confused about the meaning of volatility in forex trading and how to apply it in trading. In that case, this blog can help you understand the concept of volatility in forex and how to use it to your advantage.
What is Volatility in the Forex Market?
Volatility is a key characteristic of all financial instruments which describes the extent to which the asset’s price will be changing over a specific period. If the price of a trading instrument fluctuates a lot in a short span of time, it is considered to be highly volatile and if it does not move much, it has low forex volatility. In the forex market, volatility can be described as the degree to which currency pair prices move back and forth during the timeframe that a trader is considering for market analysis.
This can include a sharp increase and decrease in the price, and you may see drastic price jumps and falls happening on the price chart. Exotic pairs are the most volatile out of all currency pairs and the minor or cross pairs come second in terms of volatility. Major pairs are the most stable ones and thus they have lower volatility in comparison to other pairs. However, an excess amount of volatility with low liquidity can lead to slippage and price re-quotes and that is why traders are suggested to not trade during volatile hours with low trading volume.
Why is Volatility Relevant in Forex Trading?
The volatility of a trading instrument is measurable with standard deviation and this helps us to predict the potential price movement that can happen in a currency pair. Forex traders often use tools like volatility indicators to check the market volatility before the execution of a trade. If you monitor the price movements on a candlestick price chart, you can understand how volatile a pair is during a specified period. If you see longer candlesticks formed on the chart, it suggests a higher level of volatility which causes sharp price rises or price falls.
We often consider the market to be volatile during an uptrend and downtrend, but the sideway movements without any significant increase or decrease in price also indicate volatility as the prices move back and forth within a tight range. In any case, we can’t deny the fact that the level of volatility is directly linked with the profit potential of a trade as the number of pips we can catch in a trade depends on the volatility. Tools like profit calculators are useful for getting accurate profit estimates of a trade in advance.
Another thing to note here is that the volatility of a currency pair is not fixed and it keeps changing based on a number of factors. The market becomes more volatile when there is an important news event or economic data release that reveals the strength or weakness of an economy and its currency. For instance, the EUR/USD pair will become more volatile ahead of the interest rate policy announcements by the Federal Reserve and ECB. Hence, it is evident that the macroeconomic and geopolitical factors do impact the volatility of a pair.
How to assess volatility by counting pips?
The number of pips by which the price of a currency pair moves can be used to assess its volatility at the moment. A common tool that many traders use to determine the volatility of an instrument is the Average True Range (ATR) indicator. A low ATR value indicates low volatility and a high ATR suggests high forex volatility. When you are counting pips, you can compare different pairs and check which pair has moved more based on the number of pips that can be caught in a specified period. The pair with higher pip movement is more volatile and pairs which only move a lesser number of pips are less volatile.
Typically, a pair that moves 70 pips on a daily average is considered to be a volatile pair and extremely volatile pairs may record a movement of 100 pips or more. GBP/JPY is an example of a highly volatile pair with 100+ pip movement a day. But pairs that are less volatile like USD/CHF don’t move beyond 40 to 65 pips on a daily basis. EUR/USD is the most traded pair with the highest trading volume and liquidity but when we look at the volatility of the pair it is very low in comparison to other pairs.
Should You Trade Volatile Pairs?
Beginners are always advised to not trade highly volatile pairs as they increase the risk. The risk is lower when you trade with major pairs that have high liquidity and low volatility. However, you still need to make calculated moves and pay attention to risk management. When it comes to calculations, it is better to use automated tools like trading calculators to calculate risk and reward, position size, lot size, margin and other parameters with a higher degree of accuracy. This saves you from the risk of committing mistakes due to manual errors and also reduces the time and effort required for calculations to a great extent.
Now coming back to trading with volatile pairs, it is a personal preference and one needs to consider their own risk tolerance and trading goals while selecting the pairs. Those who are fine with the risk while aiming for a bigger gain can surely consider trading with volatile pairs but those who are not ready to deal with the risk should stick to major and cross pairs that are not very volatile.
Dealing With Volatility As A Forex Trader
Volatility is quite essential for a trader as they won’t be able to make any profit by trading an instrument that is not volatile enough. Forex volatility is important to make profits from trading but it also increases the risk of losses as the market can move in any direction. A favourable price fluctuation allows us to earn profits and when our analysis goes wrong, we end up with a loss. Setting a favourable risk/reward ratio and trading with a definite stop loss can reduce the risk to a great extent. Hence, risk management is essential for dealing with volatility.
Final Words
To summarise, understanding the concept of volatility is important to manage the risk that you are taking as a forex trader. So, take your time to learn about it and apply this knowledge to make profits.
