July 1, 2022

Everyone who has ever dealt with trading has come across such a thing as volatility. It is easy to guess that this concept is important, since it is talked about, discussed in textbooks and various articles. The choice of a trading strategy, money management and, accordingly, the success of trading depend on volatility. But what is volatility? Let's figure it out.

The Concept of Volatility in Complex and Simple Words

The most common definition in textbooks is: “Volatility is a statistical financial indicator that characterizes the variability of the price of something.” And further: "Volatility is the most important financial indicator and concept in financial risk management, where it is a measure of the risk of using a financial instrument for a given period of time."

Simply put, volatility is the degree of stability of fluctuations in the exchange rate of a currency or another asset: a stock, a stock index, gold, oil or cryptocurrency. If the change in the value of an asset in a given period occurs evenly and within the expected range, the volatility is considered low. If we see sharp, uneven exchange rate jumps with a large spread, this is a sign of high volatility.

In case of high volatility, the price chart shows large bars or Japanese candlesticks in one direction, or, conversely, a sharp, repeated trend change. We can very often observe such a situation after the release of any important economic news or in the event of unexpected geopolitical events.   

Low volatility indicates that the market is calm, sleeping, or dormant. This situation happens, for example, during the Christmas holidays, bank holidays or before the end of the reporting period, a month or a quarter, when large banks and funds sum up intermediate results. The market often freezes in anticipation of the publication of important macro-economic indicators, such as, for example, NFP (non-farm payrolls): the number of new jobs outside the US agricultural sector.

It should be borne in mind that trading activity, both in general and for specific currency pairs, also varies during different trading sessions. For example, the Pacific session is characterized by rather low volatility and is the calmest. The maximum trading volumes are reached at the intersection of the European and American sessions. The activity reaches its greatest extent at this time, since these are the two largest world markets: 70% of all Forex transactions occur during the European session and 80% during the American session.

Periods of low volatility are clearly visible on the charts in the form of narrow side corridors (they are usually called flat). However, a calm, uniform movement along the trend in a certain channel can also be considered a period of low volatility.

Well, it is clear that if there is high and low volatility, then there should be typical (standard) volatility, which corresponds to the average distance between the lows and highs of the price in a certain period (day, month or year).

What Volatility Is and What Traders Need to Know About It1

What Other Volatility Exists

So, we divided the volatility by the range of fluctuations into low, typical and high. However, it is worth mentioning one more gradation. Simon Vine, a financier and specialist in trading and investment operations, divided volatility into three more types in his book "Options. A Complete Course for Professionals”. These are:

- Historical volatility (similar to typical) is the actual value equal to the standard deviation of the asset price over a certain historical period of time. As a rule, historical volatility is considered on average for a period of 1 year or more. For example, the historical volatility of the EUR/USD pair during the Asian trading session is 61 points, and it rises to 97 points at the intersection of the European and American sessions. The corresponding values for the GBP/JPY pair are 112 and 145 points, while for the AUD/USD they are only 38 and 53 points.

- Expected historical volatility is a chronicle of forecasts for expected volatility, which allows you to understand how these forecasts were correct or erroneous;

- Expected volatility is a market estimate of volatility for the future, which is calculated based on the current value of an asset, taking into account possible risks.

It is clear that of these three parameters, the last one is the most important for a trader, since it is this parameter that determines the strategy and the moments for opening and closing trading orders. Expected volatility depends on a number of factors, including historical and expected historical volatility. It is also necessary to take into account the current economic and political situation, and upcoming events (release of macroeconomic statistics, market conditions, elections, trade sanctions, hot conflicts, etc.). In order to get a fairly accurate forecast, you also need to add to all this technical analysis readings, including those support/resistance levels that the asset has to overcome.

Volatility and Flat Indicators

It can be seen from the above that it is quite difficult to make a forecast on the volatility of a particular trading instrument accurately and promptly. This is where indicators can come to the rescue, many of which are already built into the standard interface of the MetaTrader 4 (MT4) trading terminal. This platform has been the most popular in the world for many years, and that is why the NordFX broker offers it to its clients.

Volatility indicators can become an indispensable tool for you and will allow you to clearly see and analyze the amplitude of price fluctuations of a particular trading asset on each of the timeframes. Based on this analysis, it is possible not only to determine the current trend, but also to make a forecast for the future, as well as calculate entry and exit points to the market, taking into account the possible price slippage. We will not describe in detail the instructions for using these indicators here (they can be easily found online), just mention the main ones and give them brief characteristics.

ATR (Average True Range) - this indicator was invented by J. Wells Wilder in 1978 and allows you to determine the real range of price movement.  Low values of this indicator indicate a sideways trend, while higher values are a sign of the formation of a new trend movement. ATR is suitable for working on any time frames; however, this indicator was originally created for daily charts (D1).

Bollinger Bands is another standard MT4 indicator that was developed in the early 80s by John Bollinger and clearly shows the change in volatility in Forex and other markets. This indicator is based on Moving Averages that form a channel. The distance between the outer bands widens with price fluctuations and trend strengthening and narrows during periods of market consolidation and low momentum trends. Simply put, if the channel expands, volatility grows; if it narrows, it falls.

The CCI (Commodity Channel Index) indicator is an oscillator that was developed by Donald Lambert in 1980 and is also built into MT4. CCI is very popular because it allows you to identify cyclical trends not only for commodity markets, but also for stocks and Forex. It measures the deviation of the price of a financial instrument from its average value. We can talk about increased volatility when the indicator line crosses the +100 or -100 levels.

It is also worth mentioning such a well-known indicator as Alligator. True, unlike the ATR, Bollinger Bands and CCI, it is usually referred to as a flat indicator.  The Alligator is based on 3 Moving Averages, and when these lines are in an intertwined state and do not have a clear angle of inclination, it is considered that the market is dominated by a flat.

In general, it should be noted that there are a lot of volatility and flat indicators. These are both unique author's developments and modifications of existing ones. They can either be bought on specialized Internet resources or downloaded for free. Some of them, even very expensive ones, may be completely useless. Other, free ones can be of invaluable help to you. In addition to the indicators themselves, there are many trading strategies using them. However, before moving on to trading with real money, as usual, we strongly recommend that you try out these indicators and strategies on the NordFX free demo account. It is quite possible that you will be able to optimize their work for a specific asset and in accordance with your trading skills and preferences. And this, in turn, will help you achieve great success in the financial markets.

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