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What is Currency Volatility, and How Do You Take Advantage of It?

What is Currency Volatility, and How Do You Take Advantage of It?

From the demolition of the Russian ruble in 2014 to the crashing of the Swiss franc a year later, the Forex market is as unpredictable as any form of trading gets.

We often expect USD or GBP to be reliable investment vehicles. But, the truth is that the global foreign exchange is just as prone to volatility as any other instrument.

What is volatility? Can we spot it coming? And is there anything that we can do to protect our investments?

What is currency volatility?

While we don’t like to think about it, the truth is that none of us knows what’s around the corner.

Take the coronavirus pandemic, for example. Could we foresee it happening? Could we predict the consequences of this virus?

Of course not, and the upshot is that all markets have been checked beyond comprehension.

It could take years for global economies to right themselves. And, as the stock market returns to its 2020 highs, the reality is that Forex remains some way behind.

Is volatility always a bad thing?

From the perspective of a slightly selfish trader, of course not.

While volatility is a major threat to a trader’s holdings, it can also be a source of opportunity for those who think fast.

Let’s think about the causes of currency volatility, COVID-19 aside. It could be due to inflation, interest rates, a downturn in GDP, trade embargos, reduced manufacturing output/production, political instability, or an unpopular fiscal policy. However, this is only scratching the surface.

These can be, to some extent, predicted. So, for traders who have the foresight to take advantage, there are ample opportunities at play.

Can we predict volatility before it happens?

Unfortunately, the clue is in the name. There is no way that we can predict volatility in advance. Google a definition of ‘volatile’ for an explanation of why!

However, you can monitor volatility as it happens, and get a rough ‘guesstimate’ as to what will happen. We do this using measures such as historical volatility and implied volatility.

We can use charting tools as a way of examining past volatility peaks and troughs to try to predict what will happen the next time a currency pair is hit.

As for implied volatility, traders use calculations such as the Black-Scholes model – you can read up about this online.

Managing risk in a volatile market

It is nigh-on impossible to completely shield yourself from the problems associated with volatility.

That said, there are currency pairs that are less at risk in a volatile market than others. As such, it can pay to invest in these if you are new to trading in times of aggressive price changes.

You should be aware that major currency pairs tend to be the less volatile ones. The likes of USD/GBP, USD/AUD, and USD/CHF will see less of an effect in a time of volatility than the minor pairs or ‘exotics’. This is useful for traders who hold for a medium to long amount of time.

Of course, if you are a day or swing trader, volatile Forex currencies will provide the most risk and reward. Which are often conditions in which some investors flourish.

Remember, some volatility is caused by low volatility in the market. This pushes spreads wider and means that traders can sometimes not access the prices they want or need. This can happen at incompetent trading brokers. As such, it is always recommended that you read a Forex broker review before signing up with a particular firm.

Trading strategies to combat volatility

What is the main issue with volatility? Quite simply, it’s exposure to risk that is beyond your control.

The fundamental way to combat volatility is to minimize your risk. As we have seen, we can do that by trading only those currency pairs with solid fundamentals.

Advanced traders will use technical analysis to determine volatility and act accordingly where possible. Indicators such as RSI, Bollinger Bands, trading volumes, and strength/resistance levels can, to some extent, predict future volatility or at least provide a guide as to how the current period will play out. As ever, newcomers to trading are encouraged to learn about technical analysis tools and their applications.

Profiting from volatility requires the ability to spot opportunities and to get in and out of the market before it turns against you – no mean feat.

For most, keeping trading to a minimum during periods of volatility, with small positions and stop losses in place, is the only way to trade.

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