Volatility: Its definition and function
‘Volatility’ is what we call a measure that enables us to know the strength of the movements or variations in the price of an asset over a given period. Generally speaking, the volatility is calculated on a daily basis but this analytical period can vary according to the type of market studied.
Volatility therefore enables us to obtain information on the stability, or, to the contrary, the instability of a market. We know for example that the higher the volatility, the more the observed movements will be bigger, and the contrary for the inverse situation. It is therefore more advantageous to trade during the highly volatile periods.
The professional traders and investors regularly use volatility analysis, either the historic volatility or implicit volatility.
Historical volatility and its analysis:
This volatility analysis tends to evaluate the volatility of a period prior to the actual time but it offers a certain utility for analysing the current volatility.
However, it is best to use the historical volatility as a complementary analysis and not limit yourself to a single indicator as other elements could interact with the effects of announcements to modify the level of volatility obtained such as risk aversion or general market conditions.
It is therefore only by placing all these factors side by side that we can obtain the most possible reliable level of volatility for the current period and that of the future.
Implicit volatility and its analysis:
This is the most interesting part of a volatility study as the implicit volatility indicates the coming volatility of an asset’s price. Its calculation is essentially based on the difference between supply and demand and also takes into account other influential factors as previously stated.
The so called ‘announced’ effects are often linked to strong market volatility. To correctly analyse the implicit volatility it is therefore essential to stay informed of all events and regularly consult an online economic calendar.
To complete volatility calculations it is possible to use technical indicators that have proved beneficial in the past and are commonly used by financial professionals, these include Bollinger Bands or other general indicators that use the moving averages in their calculations. These tools are often available to you for free through online brokers and banks, but they should be used in combination with your feelings and forecasts relating to the reactions of other traders.
Here are some examples of the usage of volatility data
As we mentioned above, the choice of a highly volatile or non volatile currency pair depends on your style of trading.
In scalping, this volatility factor is important as all Forex operations are completed over very short durations and therefore generally with small but accumulative profit margins. It is therefore necessary here to have a high volatility level to successfully accomplish this type of investment and especially do so in a profitable manner, and also with low spreads. By choosing a highly volatile currency pair with a low spread, you will have higher profits with less expense.
Swing trading takes the currency pair volatility less into account. Indeed, it is possible to trade with a larger choice of currency pairs. Therefore the swing traders who work over longer periods can simultaneously use volatile currencies and others that are more stable.
How does volatility evolve?
Of course, volatility is not a constant phenomenon and it changes with time due to the relative economic situation. Therefore, when the economy is positive, a low volatility is generally observed whereas when the economy is fragile or in danger such as in recession, this involves a rise in volatility.
It is therefore necessary to not always choose the same currency pairs, but to regularly check how the volatility evolves and adapt your choices accordingly.
Use volatility as a signal:
The volatility analysis of a currency pair can also help to determine the most appropriate moment to enter or exit the market. As indicated in the example above, it is recommended to trade in a highly volatile period when Scalping and to opt for a lower volatility for Swing trading.
Generally, the trading duration should take into account the volatility level, as a high volatility will be favourable to short term profits, a lower volatility will be perfect for longer positions
To summarise, volatility analysis is an essential tool for all good traders and allows you to maximise your chances of making profits on the Forex.