Quite often, traders in currency markets may choose a particular asset or trading strategy and stick with that as long as it remains profitable. But what if conditions change? Just as we may want to use different types of clothing for differing types of weather or adjust our routes to accommodate changing traffic conditions while we are on the road, traders will want to use differing trading strategies for volatile currencies and stable currencies. In currency markets, volatility can arise at any time, and it's best to be prepared ahead of time with a strategy in order to avoid unnecessary losses and maximise profit opportunities.
What Is Volatility?
High volatility is characterised by wide price swings of a particular asset in a short period of time. Volatility can be thought of as a market condition, and nearly all currencies may show volatility at one time or another. However, some currencies may be more susceptible to volatility under certain circumstances, or frequently, given the inherent characteristics of the underlying economies that they represent.
Identifying Stable Currencies And Volatile Currencies
While almost any currency can experience volatility at a given moment, certain currencies tend to remain more stable against their peers. These will generally be currencies representing economies that have diversified production of goods and services, low inflation, stable trade and balance of payments indicators, stable political systems, balanced government accounts, and stable and predictable monetary policy.
Traders who can identify currencies of economies with these characteristics may have more success in implementing range-trading strategies, where the price of a currency fluctuates between relatively fixed highs and lows. However, when one or more of these indicators is unstable or in a period of transition, there is a strong likelihood that the price of the associated currency may show volatility. This may also be due to adjustments made to external conditions.
This was the case, for example, in a much-discussed move in 2015 by the Swiss monetary authority, the Swiss National Bank, to unpeg the Swiss franc to the euro ahead of the European Central Bank's decision to use quantitative easing policies. The Swiss franc is normally considered a stable currency that's believed by many to be a "safe haven" for investment, and it shifted about 40% against the euro in a matter of seconds. This prompted losses in the local stock market, export and local services markets, and for many in the currency market who were not positioned for such a move.
While a sudden move of a normally stable currency like the Swiss franc is a less common event, some currencies may routinely undergo steep jumps and declines because of the less stable macroeconomic and political foundations of their economies.
How Does Volatility Come About?
But why can currency prices become so volatile? Prices of currencies are generally determined in the interbank market, where the most volume is normally traded. If there is a fast-paced change of conditions and information in the market, even the large interbank market participants can become uncertain of what the fair pricing of currencies should be. They can then become risk averse and possibly reduce the amount of available currency, or "liquidity," they offer to the market.
When this happens, the large discrepancies in prices, or "gaps," are passed on to the retail currency market where individual buyers and sellers trade. It is at this point that retail participants may see widening spreads and larger margin requirements from brokers to cover for the risk of greater potential losses among traders.
Identifying Volatile Currencies: Measurements Of Volatility
However, how can we know when a currency is presenting signs of volatility? There are several technical indicators available that can tell traders that a particular currency is undergoing volatility. One of the most popular of these is the average true range indicator (ATR). This indicator compares the high and low prices in the current trading period to the highs and lows of a previous trading period in order to detect whether the range of prices has widened. The ATR indicator tracks price movements in pips proportionally, so an ATR indicator reading change of 0.0001 would indicate a change equivalent to 1 pip.
Another tool for identifying volatility is the relative strength index (RSI). The RSI will measure the strength of a trend over a given number of recent trading periods. The sharper the movement within a given period of time, the farther the currency price may move, or possibly reverse, should a reversal be at hand.
A similarly popular technical analysis method for charting volatility is use of Bollinger Bands. Bollinger Bands compare price variations, indicated by upper and lower lines on a chart, against a 20-period moving average, indicated by a center line. When the outer bands widen, there is more volatility in the market, and when they narrow, there is less.
Another method for identifying potentially volatile currencies is strong/weak analysis. This technique involves comparing a group of currencies against a relatively stable base currency, such as the U.S. dollar, over a given time period and listing them in order of which have tended to show the most stable results. Those that consistently show weakness over time are good candidates to fall into the category of volatile currencies.
Finally, for some major currencies, including the yen, the euro and the pound, the Chicago Board Options Exchange publishes its volatility index, VIX, to show the 30-day implied volatility based on options prices. The VIX calculation, also known informally as the "fear index," was initially developed for S&P 500 index options but was later extended to other underlying instruments like commodities and currencies.
Following The News
Another obvious way to forecast possible increases in volatility is to check in on the news, at least periodically, regarding the latest economic and political events that may be affecting certain countries and their currencies.
For example, the well-known Asian currency crisis in the late 1990s was preceded by the news of two occurrences: growing current account deficits in major emerging market economies; and the ever-more-insistent reassurances offered by their government authorities that their economic prospects were good and that they had sufficient money on hand to buffer against speculative attacks on their currencies.
However, the attacks and accompanying volatility increased as these countries depleted their foreign reserves. Eventually, many nations across Asia and Latin America were forced to allow their currencies to devalue steeply.
Some Stable And Volatile Currencies
While volatility patterns may change, some currencies have gained a reputation for showing greater stability over the years. These include:
The governments behind these currencies have developed reputations for maintaining sound public sector accounts and limited interference in market affairs.
There are also major heavyweight currencies that are viewed to maintain general long-term stability. These include currencies of large nations and trading blocks, such as:
However, these currencies are viewed to have been more susceptible to policy interference.
All of these are contrasted by the volatility of some major emerging market currencies, which have been more strongly affected by local policy shifts and global supply and demand factors. These include:
Low Volatility Trading
Currencies showing low volatility may be either in range-bound conditions, favouring swing trading, or on a trend while favouring a breakout strategy.
After identifying a currency in range-bound, or "sideways," conditions, traders will want to establish floors and ceilings for their trades, known popularly as support and resistance. From there, they can establish entry points. When going long on a currency, traders will want to set a buy order when the currency price reaches the level of support and a sell order for the level of resistance. A stop loss can be set slightly below the level of a buy order.
A common risk-reward ratio for setting a stop loss is 1 to 4, meaning if a profit target is set for 80 pips above the entry point, then a stop loss would be set 20 pips below the entry point. However, if the trader has an indication that a trend will continue, they may want to implement a breakout strategy, setting a buy order for when the price breaks resistance and trailing stop losses to protect against a reversal.
Highly volatile currencies may trade within a range for a time, but they will be more prone to breakouts and erratic movements. In normal circumstances, a price breakout from a range might imply the establishment or continuation of a trend. However, in volatile markets, that may not be the case.
Prices can move rapidly and traders may be put at risk that their trade cannot be executed at the entry or stop loss positions sought. While trading strategies can be similar to those in low-volatility environments, they may require some adjustments to minimise risks and improve the potential for profits.
Among the recommendations for minimising execution risk is to widen the placement of stop losses by a factor of 2 or 3. Thus, if you customarily work with a stop-loss size of 20 pips, you may want to increase that to 40 or 60 pips. If the market moves in your favour after the entry of the trade, you can manually adjust the stop loss in the direction of your profit target.
Another recommendation is to reduce the size of your trades in relation to your overall account balance. For example, if you normally risk 4% of your total trading account balance in stable market conditions, you may want to reduce that to only 2% in volatile conditions in order to cut your exposure to losses.
Volatile conditions may arise at any time and with any currency. However, there are telltale signs of which currencies may be more prone to undergoing wide price movements. There are even hints about when customarily more stable currencies may be facing bouts of volatility. To prepare for these movements, traders should study which currencies are likely targets for price swings and keep abreast of day-to-day world events that could provoke uncertainties or large flows of capital from one region to another.
Traders are often urged to avoid activity in the markets when volatility arises in order to avoid risks, but in doing so they may also forfeit opportunities when the largest prices movements and profits are available. Fortunately, there are some technical analysis tools, indices and trading strategies that can help traders minimise risks and maximise profits even when greater uncertainties and volatility are likely to take hold.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…