When it comes to the active trade of forex currency pairings, volatility is a integral part of most strategies. Whether one is interested in pursuing profit from speculative endeavours or hedging financial risk, a currency's inherent volatility is one aspect of its behaviour that must be accounted for. If not, questions regarding the application of leverage and the degree of risk exposure become very difficult to answer.
Volatility is an important consideration in everything from forecasting weather patterns to projecting the future price action of tradable financial instruments. With the possibility of very serious consequences being realised, volatility is quantified and thoroughly vetted across many disciplines, especially currency valuations.
What Makes A Currency Volatile?
Volatility is commonly defined as the tendency for an element to change quickly and unpredictably. As applied to finance, volatility is viewed as being a measure of a security's pricing stability.) In each case, it is thought of as the result of various unexpected events influencing a system. Thus, a volatile currency is one that has historically been, or is currently being, faced with significant uncertainty.
Exchange rate volatility plays a key role in forex trading, fueling the market activities of traders and investors alike. Typically, those currencies exhibiting the highest degrees of volatility are likely subject to one or more of the following fundamental stimuli:
- Political Instability: Any change to a sitting government, via election or coup, can throw a domestic currency into chaos. In the case of many historically volatile currencies, such as the Russian ruble (RUB) or Turkish lira (TRY), political unrest and upheaval have been the cause for massive revaluations. Also, the U.K.'s 2016 vote for Brexit and subsequent impact on the British pound (GBP) is another prime example of the influence politics can have on the value of money.
- Economic Data Releases: The scheduled release of official economic metrics can bring enhanced short-term volatility to any currency. Abnormally high or low figures are capable of moving exchange rates dramatically within minutes. Reports such as Gross Domestic Product (GDP), Consumer Price Index (CPI) and various employment statistics are examples of market moving economic events.
- Changes In Central Bank Policy: The raising or lowering of target interest rates by a central banking authority can be a primary catalyst for volatility. Although central banks such as the U.S. Federal Reserve and the Bank of England use caution when making announcements, the shifting of monetary policy often drives erratic exchange rate valuations.
Uncertainty is the number-one reason for a currency to become volatile. As the age-old financial rule of thumb states, "the marketplace does not like uncertainty." Each of these fundamental market drivers—be it politics, economic data, or the actions of central banks—can potentially shake up exchange rates and contribute to a currency's volatility.
Characteristics Of A Volatile Currency
While volatility is a critical component of ongoing asset valuations, it is important to realise that it is not constant. Pricing fluctuations come and go depending upon a broad spectrum of factors. As the presence of these factors is either confirmed or denied, price action may become unhinged. The result is the "spiking" of periodic volatility.
In the event that the fluctuations in price of a currency increase, several characteristics become evident. Below are common attributes of a volatile currency:
- Wide Bid/Ask Spread: As the process of price discovery progresses between buyers and sellers, various quantities of orders hit the market. In times of imbalance and extreme pricing fluctuations, the spread between bid and ask prices can become wider than normal.
- Greater Margin Requirements: Exceptionally volatile currencies typically require greater brokerage margin requirements. Forex brokers regularly seek added protection from the negative impacts of wild price swings, thus a larger margin is warranted to insulate from undue financial loss.
- Variable Liquidity: When uncertainty plagues a currency, sporadic market participation is common. While technically open for active trade, the market may become thin. A lagging depth-of-market contributes to wide bid/ask spreads and sudden directional moves in pricing.
- Extreme Trading Ranges: Volatile currencies regularly exhibit wider than normal trading ranges on intraday and end-of-day time frames. Large pip variations from periodic highs and lows are evident, exhibiting the bolstered activity of price action.
It is important to remember that a currency's volatility can increase or decrease without a moment's notice. The impact of a sudden spike in participation can produce myriad trading opportunities, while at the same time enhancing risk exposure. Accordingly, a forex pair may become more or less attractive to a specific strategy due to wider bid/ask spreads and limited liquidity. No matter if one is a scalper, day, or swing trader, it is imperative to remain current on the prevailing levels of volatility facing a single currency or pairing.
How to Quantify Volatility
In practice, volatility is measured across the equities, futures and currency markets. One common method of accomplishing this task is through calculating a security's standard deviation.
The standard deviation quantifies the degree of pricing volatility in comparison to a baseline value for a given period. Under this methodology, pricing variations are put into context as being close to, or far away from, an average value. In this fashion, larger standard deviation values represent higher degrees of volatility, while smaller figures illustrate stability.
In order to derive a standard deviation, several steps must be performed. A basic procedure for standard deviation as applied to security analysis is as follows:
- Calculate The Mean:
- Mean = (Sum of All Periodic Price Points)/Number of Periods
- Subtract Mean, Then Square The Result:
- (Each Periodic Price Point - Mean)2
- Calculate Standard Deviation:
- Standard Deviation = Square Root[(Sum of Each Squared Difference/Number of Periods)]
Standard deviation is a detailed arithmetic exercise that requires substantial time to perform manually. Due to this fact, many software trading platforms include automated calculations in their analytical suite. This functionality provides traders with a means of implementing standard deviations in a real-time market environment.
Volatile Currencies In Action
Given the constitution of the modern forex, a currency's volatility fluctuates in accordance with a variety of fundamental and technical factors. Major, cross, and exotic forex pairs all exhibit variable rates of volatility in relation to the local influences facing each prospective currency. As a result, a specific currency may exhibit both periodic stability and volatility depending on its forex pairing.
Using standard deviation to quantify currency volatility, the GBP experienced a stretch of extraordinary action during the fall of 2018. The chart below lists the top five most volatile currency pairs in terms of a 20-day sample from 25 October to 14 November of 2018:
In the table above, notice that the GBP is included in the top three volatile pairs for the given period. The dramatic swings in pricing, shown by the extreme standard deviations, were due to market uncertainty created by the Brexit transition process. Issues surrounding the future of U.K. trade, immigration, and finance plagued the GBP, prompting it to become a volatile currency.
From a trading standpoint, market fundamentals are the most common drivers of forex volatility. Global currencies are susceptible to these influences on an ongoing basis. Given an evolving local political or economic situation, any currency listed on the forex is capable of becoming volatile.
The concept of volatility can be a challenge to fully quantify and comprehend. In fast moving environments such as the forex, it often suddenly appears and disappears on a daily basis. However, by implementing the proper technical tools, periodicity and understanding of market fundamentals, identifying a volatile currency can become elementary.