Volatility is a crucial element to understand in any market. Monitoring and interpreting volatility is more than just knowing how much a forex pair typically moves in a day.
Certain hours of day have more volatility than others, and certain days of the week are more or less volatile on average. Long-term changes in volatility also affect how forex traders approach the market, and therefore, also the strategies employed.
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Understanding Forex Volatility
In the stock market, most people consider volatility a bad thing, as it typically increases as the stock market drops. In forex, volatility is simply how much a pair moves. Volatility can be monitored by the minute, hour, day, week or by longer time frames.
If one currency is rising that means the other currency in the pair is falling. For example, if the EUR/USD is rising, the euro is going up in value, and the U.S. dollar is going down in value (see Forex Trading 101).
Therefore, volatility doesn’t have the bias it has in the stock market. Volatility can increase or decrease during both uptrends and downtrends in a currency pair, interchangeably. Volatility tendencies and changes in volatility tell us a lot about how we should be trading.
Hourly volatility is most relevant to short-term forex traders, but isn’t a major factor for forex investors.
The various global trading sessions affect volatility within the 24-hour period. Figure 1 shows major forex global trading sessions, in Greenwich Mean Time (GMT).
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A forex pair is typically most volatile when one or two of the markets associated with it are open for business. For example, the EUR/USD is most volatile and active when London and/or New York are open because these markets are associated with the EUR (euro) and USD (U.S. dollar).
Volatility charts courtesy of: VantagePointTrading.com/Daily-Forex-Stats
Between 1300 and 1700 when both London and New York are open is when the EUR/USD experiences the most volatility.
Trend trading is likely to work better for day traders during the more volatile hours of the day, while more ranging type strategies work better when the volatility is lower and the major markets associated with the pair aren’t open to push it around.
Volatility changes over time, affecting the amount of pips a pair typically moves during certain hours of the day. Hour 12 may increase to see 40 pips of movement, or drop to only 19 pips, but generally it’s the most volatile hour of the day. Therefore, the hourly tendencies don’t change very much, but the actual pip movements seen during those hours are constantly changing.
Day of the Week Volatility
Trading a certain pair you may find your 50 pip target is easy to hit on Thursday, but you’re hard pressed to make 30 pips on a Monday. Each pair has different day-of-the-week tendencies; some days have half the volatility of others. If you’re trading each day the exact say way, you may find a pattern of better or worse performance on certain days.
Looking at average volatility over the last 100 days, for example, each day of the week has its own average.
Adjust expectations based on the day of the week. During this 20-week period for the EUR/USD a day trader could expect to make much more (due to the larger moves and more opportunity) Monday to Thursday, than they could expect to make on Friday or especially Sunday. Expectations also need to be tempered on a Monday, when compared to a Wednesday.
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How much the pair has moved on average, per day, over the last several years tells us a lot about current market conditions, how much we should be trading, and even what is likely to happen with the pair in the future.
When volatility is near multi-year lows, there are fewer trading opportunities. Day traders and short-term traders should be more restricted in what they trade. Commissions and the spread (difference between bid and ask price) affect a trade much more when a pair is only moving 40 pips a day, compared to when it’s moving 120 pips per day . The cost to trade is the same, but the reward potential for that cost is lower (this is not a direct relationship though).
In Figure 4, near the start of 2014 there were fewer trading opportunities as volatility was contracting. During such times, trade more cautiously, as moves are likely to run out of steam quickly, and price action can be choppy. Come July, volatility began to pick up again, signaling a more trending environment where moves are more likely to extend and typically the trading is less choppy.
Sharp changes in volatility often accompany a trend change; this is because trends are often complacent and see declining volatility. Reversals change that. The status quo is shaken and complacent traders are forced to exit their trades quickly, or face major losses.
Learn more about Trend Reversals: How to Spot and How to Trade.
Volatility Adjusted Trading Methods
A fixed strategy, such as risking 20 pips to make 60 may work in some market conditions, but not others.
Consider using an indicator such as Average True Range, or monitor the volatility of forex pairs on a regular basis to establish what the proper stop loss and target levels are for current volatility. At times you may risk 10 pips to make 30 with a larger position size, and as volatility increases, you reduce your position size and risk 30 pips to make 90 (just as an example).
The Bottom Line
Volatility is more complex than how much a forex pair moves each day on average. By zeroing in we see volatility varies drastically, and consistently, across different hours of the day, days of the week, and over time. Monitor and adapt to these changes. Be aware of how volatility is measured, and constantly monitor it so you can adjust your expectations accordingly.