Complete Guide to Dealing with Currency Volatility
Multinational companies based in North America and Europe welcomed 2022 rather grimly, what with a highly reputed Currency Impact Report (CIR) revealing nearly $12 billion in total impact to earnings from FX currency volatility in Q3 of 2021 alone. CFOs suddenly came under fire for not doing enough to mitigate risk despite threats to organizations' financial stability and supply chain.
The most obvious effects of currency volatility are sudden and intermittent variations in exchange rates. Even some of the best forex managed accounts have been known to fall prey to this phenomena. Hence, if you are to achieve your financial goals, it is vital that you appreciate the raw, unpredictable nature of forex volatility.
This article will shine the spotlight on FX volatility, show you how to recognize it, help distinguish it from risk, and reveal some strategies for you to counter it.
Meaning
In the simplest terms, volatility is an expression of the frequency and magnitude of variation over a period of time in a currency’s value. A currency’s volatility is judged based on how much its value deviates from the average. Traders dropped into a highly volatile market are caught in something of a double-edged situation: Large and erratic price movements not only raise their trading risk, but also provide them with excellent opportunities to hit the jackpot overnight.
One of the easiest ways to visually represent a currency pair’s volatility is to plot its value variation over a certain period of time on a chart, and then juxtapose it with its Average True Range (ATR), the most trustworthy measurement of volatility. Let us consider a real-world scenario for a moment.
Displayed above is a chart showing variation in the value of New Zealand Dollar/US Dollar over the past 5 years, and its corresponding ATR is indicated by a red horizontal line — almost straight throughout and a demonstration that NZD/USD is a stable currency pair.
Contrast that with the chart displayed below showing variation in the value of Bitcoin/US Dollar over the same time period. Its corresponding ATR represents the farthest thing from a straight line — the red line slopes up both gently and sharply, tell-tale signs that BTC/USD is a relatively volatile currency pair.
Types
When it comes to an options trade, especially popular among top forex fund managers, volatility is widely measured through two different methods: Historical volatility and implied volatility.
Historical volatility measures price variations of a security over specific periods in the past. Since it looks back in time it’s not quite popular among traders, whose primary interest lies in the future. When a security’s historical volatility rises, it means its price will also fluctuate more than normal; when it drops, it means any uncertainty surrounding the price has vanished.
Implied volatility, on the other hand, is more popular among traders because it provides an indication of how volatile the market will be in the future, or the anticipated volatility of the price of an option. Its output cannot be claimed as exact science, but just as an expression in terms of probability. Instead of relying on past performance, practitioners of implied volatility rely on the current and future potential of the option — i.e. demand and supply levels.
Differentiation from Risk
In many trading circles as well as in managed forex trading, the unpredictable nature of the forex market has erased the distinction between volatility and risk. Just to be clear, they are two different concepts.
Management of risk falls within your sphere of influence; market volatility falls outside it, unless you are the biggest trader in the world. On any given trade, you get to choose exactly how much you are willing to risk or put on the line, and how to manage it; in case of volatility, market forces have the ability to upset even your best laid plans.
At the same time, volatility and risk are also strongly related. As discussed earlier, volatile currencies are something of a double-edged sword and have a tendency to attract risk-takers, and where there is one, a herd is bound to follow. Hence, always be fully aware of the risks posed by a trade during a period of high volatility. As cliched as this sounds, rely on your own judgement rather than following in the footsteps of others, something made easier if you have a sound forex money management plan of your own.
Tips to Deal With High Volatility
There are some more forex money management strategies that can be pursued to maximize the value of your trades or, more importantly, at least limit the damages you sustain during a period of high volatility. Integrate the following into your trading plan and test them rigorously for the best results.
1. Charts & Indicators: Rather than relying solely on ‘gut instinct’, pretty much every forex fund management company employs special teams whose sole purpose is to pour through charts and make sense of indicators in an effort to anticipate future price movements. Although including them in your workflow won’t guarantee profits, they are sure to improve your overall decision-making.
2. Aware of World Events: Forex price fluctuations are heavily influenced by developments in real-time from all over the world, both politically and economically. If you are to somehow stay one step ahead of the market, then you should be constantly aware of what is taking place in any major country, at any given time.
3. Stop-loss is Your Best Friend: Whenever it feels like the market is going crazy and the whole world is out to snatch away what’s yours, the only friend that will stand by and help you is the stop-loss mechanism. Regardless of whether you make your own trades or employ forex-managed account services, it is the best way to ensure that your losses stop at an acceptable level. It takes on even greater responsibility if you are trading with leverage.
Trading during volatile market conditions is a juggling act even the most experienced traders cannot keep up for long. So take in the information provided in this article and do your best to eke out profits or minimise your losses, and if you still feel overwhelmed by the circumstances, know that the most courageous thing you can do is to take a step away from trading.