The market’s estimate of how much a currency pair will fluctuate over a certain period in the future is known as implied volatility. For online investors, a volatile market means both potential risks and an abundance of opportunities. Many traders follow market news and economic calendars in an attempt to recognize potential volatility, benefit from it and stay ahead of the market. Volatility is a useful concept for forex traders that can give them a sense of the risk involved in trading a particular currency pair.
Volatility (in forex trading) refers to the amount of uncertainty or risk involved with the size of changes in a currency exchange rate. A higher volatility means that an exchange rate can potentially be spread out over a larger range of values. High volatility means that the price of the currency can change dramatically over a short time period in either direction. On the other hand, a lower volatility would mean that an exchange rate does not fluctuate dramatically, but changes in value at a steady pace over a period of time. Commonly, the higher the volatility, the riskier the trading of the currency pair is.
Forex traders traditionally chose currency pairs for their investments on the ground of classical risk/return analysis. Moreover, both return and risk are assessed in each separate moment or, in the best case, for certain discrete time series. In reality, actual price quotations change constantly at a different pace: sometimes quickly, sometimes slowly. That is why among all other market characteristics a lot of attention should be paid to volatility as a quantitative measure of past, current and future price range of a currency pair. Ultimately it gives the possibility of estimating, not only potential return on investments but also risks exposure.
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 stable political systems 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.
Several different ways of using the term volatility are in common usage among forex, currency futures, and currency options traders. Implied volatility in the forex market is the annualized volatility implied in the market-determined prices of currency options for a particular expiration date. This market determined form of volatility can be used to assess what the expected future risk for trading in a particular currency pair might involve since it factors in option traders’ expectations for future price swings. Historical volatility, on the other hand, can be mathematically defined as the annualized standard deviation of price movements from the average price observed over a period of time. This calculated form of volatility can be especially useful in determining the risk that trading a currency pair might involve, based on what it has done in the past.