Volatility Forex Trading
Volatility is a quantitative measure of standard deviation, which is the amount of dispersion of a set of values from their mean. When you apply standard deviation to a long-term return rate in the market, it gives you the volatility present in that particular market. For example, volatile stocks deviate greatly from their average price, which means that the standard deviation values are large. On the other hand, stable stocks lie between a lower price range.
A very good example of a volatile market is the forex market. Just like other financial markets, it is affected by various macroeconomic factors, with liquidity being the most important one. This is because liquidity is directly connected to demand and supply. So, currency pairs such as GBP/USD tend to be less volatile than GBP/JPY, since the former is more widely traded.
Types of Volatility
Now, volatility can be of two types, implied and historical. Any sudden, abnormal, or recent future price action is categorised as implied volatility. Conversely, volatility that is present over a longer period of time, such as a year or a month, is historical volatility.
At times, the forex market may become quiet for several sessions or days. This can give you the idea that it is easy to trade in forex. Then, suddenly, there could be a movement of hundreds of pips in a matter of a few hours. So, to properly navigate through this temporary, chaotic phase, it is important to know the various volatility trading methods that can help you minimise risk and maximise chances of success.
Minimise Losses
When there is high volatility and price action is choppy, it is better to make use of small stops and set larger take profit targets. This volatility trading technique can prove to be useful in case of a highly volatile forex market.
If the price has stayed within a specific range and is continuously trading within it, you can put stops just above the top, when you want to sell, and below the bottom, when you want to buy.
It is very difficult to predict when the price will break out of this range and for how long it will run when that happens. So, it is generally better to put a tight stop loss.
Increase Portfolio Diversity
Diversification is a good technique to survive the financial market over the long term. Many large institutions make it a point to increase the diversity of their portfolios by adding many different instruments in different markets.
When it comes to high volatility situations, the importance of diversification cannot be overemphasised. Under normal trading conditions, it is not possible to accurately predict the result of a trade and this uncertainty increases exponentially in a volatile forex market. So, by spreading your capital across various currency pairs, in different directions, you could decrease your risk exposure and improve chances of profit.
For instance, if you are selling EUR/USD near the resistance level and buying AUD/USD near the support, when the strength of the USD is about to end, you may get two profitable trades. And, in the worst case, you will simply hedge the losing trade and eliminate its losses. If this is done with several pairs, there is a chance that some can lead to profits, while others might break even.
Consider the Overall Impact of Volatility
Overtrading in a volatile forex market can be as bad as high leverage. You will be unable to concentrate on your trades properly if you open too many of them at the same time. Your logic can become blurred and finding a good direction can be difficult.
A volatile forex market may give you the idea that there it has no definite direction, confusing you further. So, it is useful to examine the bigger picture to avoid the influence of short-term factors. In this way, you will be able to see the important resistance and support levels of higher timeframes. This will prevent you from overtrading with smaller timeframe indicators.
Keep in mind that patience and perseverance are important during volatility trading.
Other Useful Tips
Some other tips that can be helpful in volatility forex trading are:
Keep an Exit Plan Ready
Before you decide to buy or sell, you need to decide on a proper exit position. This will help you stay calm and not let emotions rule your trading decisions. Ensure that you follow these exit levels and avoid moving them at any point of time.
Look Out for Delays
In a situation where the prices are in freefall, you could face a problem in accessing your trading account. In this situation, consider telephone access with your broker, so that you can initiate orders, if needed.
Keep Track of Price Changes
Due to high volatility, there is likely to be high volume of trade, since most people will try to limit their losses or cash in on rising prices. Remember that an order you have placed at a particular price in such a market situation might be completed at a different price.
To avoid such price gaps, you can place limit orders that define the price at which you will buy or sell.
Understand that Different Approaches Work Differently
If you have tasted success by implementing a strategy on a particular instrument, it is not necessary that it will always work equally well. You need to make constant adjustments and changes to your volatility forex trading approach, to ensure that it remains fruitful.
During a volatile forex market, the most recommended approach is to play it safe. However, if you have a tried and tested strategy that has worked in the past and you feel confident, you could use it but be careful to stick to your strategy and not get swayed by emotions of fear or greed.
Reference Links
- http://1.droppdf.com/files/gxQpD/volatility-trading-2013.pdf
- https://www.investopedia.com/articles/active-trading/032515/trading-volatility-dont-trade-stocks-trade-options.asp
- http://www.mkaranasos.com/oldsite/FEln9.pdf
- https://www.bloomberg.com/opinion/articles/2018-06-04/volatility-trading-is-a-problem
- http://www.volcube.com/resources/options-articles/what-is-volatility-trading/
