Understanding volatility: from Bollinger Bands to the 'square root of time'

This article explores the concepts of volatility. We use the plural here because there are actually multiple types of volatility.

What is volatility

In essence, volatility is the rate of change. In the foreign exchange market, volatility refers to how much and how quickly a currency's exchange rate changes over a specific period. Volatility does not indicate the direction of the market. It indicates the level of moves (fluctuations) of an exchange rate. When a specific Forex pair is said to be highly volatile, it means that this pair often moves rapidly and travels a wide range of values in a relatively short time. In other words, the price swings can be massive, sharp and unexpected. Conversely, a low-volatility pair is one whose rate changes slowly, and often stays within a narrow, predictable range with minimal sudden spikes. Volatility can be expressed as an annualised percentage, a fraction, or in absolute terms like pips.

Why traders love and hate volatility

Besides the fact that the Forex market is the largest and one of the most liquid markets in the world, it is also very volatile. And this is definitely one of the main reasons why so many people find Forex trading so attractive. High volatility offers traders more opportunities to make quick and (sometimes) large profits. However, it also increases the chances of loss. In other words, volatility is a double-edged sword. Some traders (especially day-traders and scalpers) love it for rapid profit opportunities, as quick moves can result in substantial pip gains in mere seconds or minutes. Other traders (particularly position and swing traders) hate it due to emotional pressure, wider broker spreads, and the high risk of sudden stop-outs.

Types of volatility

Volatility comes in two forms: past and future. Past, historical, or realised volatility is built from actual price data over a specific stretch of time (for example, over the last 30 days) and shows how erratic a currency pair has been over that period. This type of volatility is objective and easily calculated. Future, expected, or implied volatility represents the market's current expectation of future price fluctuations. Implied volatility is calculated based on the pricing of option contracts, which reflect how investors hedge against future market swings and at what cost.

Usually, it is the historical volatility that gets most attention because it is relatively easy to calculate. Elev8, a global Contract for Difference (CFD) broker, notes that retail traders tend to focus almost exclusively on historical volatility. The reason is quite straightforward: retail trading platforms measure historical volatility in real time through a multitude of embedded technical indicators, and traders are used to monitor it closely. However, it is the implied volatility that is more important from a trader's perspective. Unfortunately, it gets less attention because it is more difficult to calculate, and free tools for calculating it are not readily available to the public.

Rules for surviving the volatility

If you want to survive and profit from volatile FX markets, consider incorporating five key rules into your trading plan.

• Adjust your leverage and/or position size. High volatility increases your gains but can also increase your losses. Lower your leverage or open smaller positions when volatility rises.
• Diversify, don't concentrate. Never risk all your capital on a single currency pair, especially when the market is chaotic.
• Aim wider. When volatility rises, widen your stop loss and take profit levels to prevent getting prematurely 'stopped out' by market moves. Allow your position enough room to capture the larger price swings.
• Use multi-timeframe analysis. Always keep the big picture in mind. Use weekly or daily charts to identify strong key levels, then zoom into hourly charts to manage your entry points.
• Patience is also a position. Sometimes, the best trade is no trade. If you are uncertain about a massive market swing, step aside. Capital preservation should always be your first priority.

Disclaimer: This article does not contain or constitute investment advice or recommendations and does not consider your investment objectives, financial situation, or needs. Any actions taken based on this content are at your sole discretion and risk—Elev8 does not accept any liability for any resulting losses or consequences.