Using a Forex Volatility Indicator
One of the most challenging aspects of Forex trading for novices is dealing with the aspect of currency volatility. Currency volatility is defined as the measure of price variation in the Forex. There are a number of techniques to deal with both large and small price variations in currency pairs.
Adjusting the Amount of Leverage Used
Nearly all Forex brokers allow traders to vary the amount of leverage used in their trading account. If a currency pair’s price variation is much larger than normal you can scale down your leverage to compensate for that. If your trading risks 100 pips per trade, but the currency pair’s movements have become larger than anticipated, try scaling your leverage back from 100:1 to 50:1, 25:1, or 10:1. This allows you to continue to trade, but make necessary adjustments to control your risk.
Measuring the Volatility
Some of the Forex volatility indicators include Average Range (AR)/Average True Range (ATR), Bollinger Bands and Moving Averages.
Average Range (AR)/Average True Range (ATR) – the Average Range is defined as the difference between the high and the low of a particular price bar. Using a daily EUR/USD bar as an example, if the high = 1.4100 and the low = 1.4000 then the range = 100 pips. If the range was the same for 10 consecutive days then the 10-day AR = 100 pips x 10 = 1000 pips/10 = 100 pips. An Average True Range (ATR) uses a bar’s high and low in its calculation, but also includes the previous bar’s close.
So how do we use either the AR or the ATR to trade more effectively? One method is to use the AR or the ATR to judge our exposure to risk. If our trading system dictates that we risk 20 pips per trade and the AR is 200 pips it may be best for us to simply not take the trade. By staying out of trades which may have a greater probability of failure we can preserve our capital and avoid some needless losses along the way.
AR and ATR can also be used to identify “stale” market conditions. When the AR is much smaller than normal a trader may want to wait to enter a trade. This is because the smaller price movements can mean smaller profits or possibly that it will take longer than normal to reach a profit. Logically, the longer you are in a market waiting to profit, the more you are also exposed to risk.
Another good use of a small AR is for trading breakouts. Some traders wait for the price range to get smaller and smaller and form a narrow channel believing that the longer the prices stay within a narrow price channel, the more dramatic the channel breakout will be.
Moving averages is probably the simplest Forex volatility indicator used in FX volatility calculation. It is also the most effective. First, you need to determine the time period you want to cover. This can be one week or 8 straight hours or any other time period that you select. You get the closing price for each period that you have selected. These closing prices are added up and divided by the number of periods in your time frame. The calculation that results is your average.
Forex traders will look at many different averages based on different time periods. The most averages are the 10, 20, 50, 100, and 200 moving averages. You then compare the price of a currency to the average. If the price moves closer to the average then it is said to be weakening. If the price moves toward the trend then it is considered to be growing stronger. Here’s how forex trader, Jose Tormos leverages this strategy:
Each of the different moving averages is charted. Shorter periods show more volatility than longer periods. When the lines cross they can signal a turn in the market. When the line for a longer period average crosses the line for shorter period average, it indicates the market is about to turn. Savvy investors will use the information to determine when to enter or leave the market.
There are two different methods used to calculate the average: Simple and Exponential. With simple, the same weight is applied to all prices. Exponential applies different weights to the prices with the most recent prices given a higher weight.
Moving averages are used to show the current trend in price for a currency. Traders use this information to complete their trades by targeting when the best times to buy and sell are.
Bollinger Bands (BB)
One of the reasons this technical analysis tool is so useful is because of its ability to adapt to changing market volatility. The “bands” themselves are lines which run above and below a simple moving average of the prices (you can see them in the image above). Initially, bands were created by adding and subtracting a small percentage of the moving average. An upper band could be created by multiplying the moving average by say, 1.03 for 3%. For the lower band, 3% is subtracted from the moving average.
In our fixed percent example above, the bands stay at a relatively fixed distance from the moving average. John Bollinger changed the way traders looked at using price bands by creating his bands using standard deviation rather than fixed percentages. The typical settings of Bollinger Bands use a setting of 20 periods (weeks, days, hours, etc.) and 2 standard deviations. The top band is formed by adding 2 standard deviations to the moving average and the bottom band is formed by subtracting 2 standard deviations from the moving average.
Bollinger Bands give traders a lucid way of visualizing the markets because the bands themselves dynamically expand when market volatility increases and contract when market volatility decreases. Bollinger Bands can be used for Forex volatility calculation and to indicate important price highs and lows.