Volatility in Forex and Its Dimensions

This chapter reviews how volatility should be used in helping the forex trader evaluate
market conditions. Volatility conditions, when added to classical support and
resistance, and trend analysis identify high-probability trading opportunities and
patterns.
By identifying currency pair volatility and associated exhaustion conditions, the
trader gains knowledge of what the currency pair is doing. What the trader is most interested
in is the behavior at prices at the extreme. A currency pair can reach a new daily or
weekly high, but it doesn’t mean that the price is likely to return to its average or mean
price. When a currency is at a high, it is there for a reason. Perhaps new economic information
pushed it to that new level. However, it is when a currency is at volatility high
that the trader can deduce a potential for a reversal. This is because volatility cannot be
infinite, then return to an average level. Understanding the behavior of the price in terms
of volatility is a building block of forex technical knowledge.
It’s helpful in understanding volatility of currency pair prices to recall our everyday
experience with volatility. A strong snow- or rainstorm has periods of varying intensity.
But when the storm reaches its most intense period, one knows that it will soon
be over. All of us have heard the phrase “the calm before the storm.” When the price
is quiet, with small ranges and little change over time, it is recognized as a prelude to
a breakout—exactly mirroring the phenomenon of the calm before the storm. Trading
strategies emerge from applying volatility knowledge. A peak in volatility suggests to
the trader that a reversal trade may be shaping up and to be ready for that. A decline
in volatility may suggest near-term lack of any significant move, suggesting waiting for
conditions to change.

A technical quantitative measure of volatility is the standard deviation of the price
range over time. Zero volatility doesn’t mean that the price has stayed the same. It means
that there hasn’t been a change in the price range. The key notion to understand is for
the forex trader to observe market ranges and notice whether they are stable or varying.
Once a currency pair starts changing frequently the shape of its range, we have
volatility increasing. A surge in volatility may be a prelude to continued movement in
the direction of the surge. New energy coming from increased sentiment has to go somewhere.
It’s important to note when a surge occurs, if it occurs at a key resistance, it
may be a reversal indicator as well. Trading volatile markets that have expanding and
contracting ranges requires special attention to risk controls because the trader has an
expectation that the price can fluctuate more rapidly and more widely.
We see a recent visualization of the volatility increasing. The currency
pair British pound-Japanese yen (GBPJPY) experienced a significant increase in volatility
right before and after the February 2007 Bank of Japan’s decision to increase interest
rates. Notice how the volatility ebbed into a very quiet and narrow range afterward. A
good clue to volatility is when it takes only one or two candles to pass through the range.

Visualizing volatility is helped by the use of several technical indicators, which we
will discuss in the next section.




By ABE COFNAS