How to Measure & Use Volatility on Forex - Practice

What is Volatility?

First, what is volatility? In finance, volatility is a measure of the riskiness of a security. A high volatility means that investors can lose money in a relatively short period of time. Volatility, when translated into currency is typically measured in percentage. A currency with a high volatility is one that could fluctuate in a very unpredictable way in response to the price of another currency.

And what is risk?

Risk is an expectation for a certain monetary value to occur. Volatility is not a measure of the money value of the forex pair (either positive or negative). It is a measure of the possibility that the price could change by a set amount in one day, one week or one month.

For instance, the forex pair EURUSD can be volatile up and down, or it can be relatively stable up and down. The volatility is what’s called “defined”; this means that if we use it as a basis for calculating the expected monetary value of this pair, it will be more predictable and easier to use for trading. In order to check top forex brokers list you can check here.

How to Check Volatility in Forex?

Although many strategies can be used to trade forex, generally, the optimal strategy is to calculate the volatility of a currency pair. To do this, you need to know the volatility of the currency, the volume of trading in the pair and the trading volume. All of these are used to calculate the value of the pair.

Getting the actual value of the pair is as easy as calculating the currency’s interest rate, for example: 1 USD = 1.0 Xe.

Interest rate is the inverse of volatility, since the more volatility, the higher interest rate is (therefore, volatility is higher than interest rate).

Why is Volatility Important?

When planning a trade, it’s important to consider the volatility of the currency pair. If you calculate the volatility, it will help you set a trade strategy.

Some examples of volatility calculations that might help you with your trade decisions:

·       Daily: If there is a day where the volume of the pair is higher than usual, the volatility is usually higher than usual. Hence, we can interpret this as meaning the price has become more volatile.

·       Spot volatility is similar to daily volatility, except that it can occur at any time and it depends on the time of the day that the trade was initiated.

·       Volatility is usually defined by the range that a pair usually reaches (often between 1-50%).

·       Pairwise volatility: Sometimes there is a trade that is stronger than the other, and when there is a cross-currency trade, the pair with the lower volatility usually has the upper hand. In this case, the pairwise volatility is usually higher than the average of daily volatility.

·       Volume of traded pairs: The more currencies that are traded, the higher the volume.

Formula for Volatility Calculations:

In Forex, the volatility can be calculated in several different ways.

Example: EURUSD pair

To calculate EURUSD volatility, one can calculate the following formula:

vol = log (Trading Volume / Trade Quantity)

log (Volatility) = daily volatility

i.e., the daily volatility of EURUSD can be written as:

Vol = (Daily Volatility) / (Trade Volume / Trade Quantity)

Hence, by using the above formulations, you can easily check volatility in forex!