What is Volatility?

Trading terminology is quite wide and comprehensive. One of the most commonly used by market participants concepts is volatility. This concept plays a central role in many areas of finance and it can be a great aid in conducting successful trades and foreseeing the asset movement. This article will cover what the phenomenon of volatility is and how it can be used in trading in favor.

What is Volatility and How it Works in Trading?

Need to mention an alternative explanation of the volume-volatility correlation, that is based on the “mixture of distribution hypothesis” first proposed by Clark (1973). According to this hypothesis, volume and volatility are both driven by a common, unobservable factor. This factor reflects the arrival of new public information and determines a positive correlation between unexpected turnover and unexpected volatility. So, volatility is the frequency and magnitude of price movements, up or down, that measures how much the price of a security, derivative, or index fluctuates. The bigger and more frequent the price swings, the more volatile the market is said to be. 

It is worth noting that, the price movement on the chart may sharply go up or down, with little or no trading in between, this area is called the "gap". It is worth knowing that gapping may occur when economic data is released that comes as a surprise to markets, or when trading resumes after the weekend or holidays. 

Furthermore, in Foreign exchange, currency volatility is a measure of the frequency and extent of changes in one country’s currency’s value vis-à-vis another currency. The important factors affecting the volatility of a specific currency are interest rates, inflation, government debt, current account deficit, political stability, dependence on commodities as well as geopolitical crises, etc. 

What is the Phenomenon of Volatility?

To speak plainly, volatility is an important yardstick of an engine in the market. It does not seem to let traders “fall asleep”. With low price changes, there are few trades, high fluctuations bring income. The larger the gap, the higher the profit and, consequently, the risks. As soon as the value of assets begins to swing, large investors enter the market and start a transaction flow.

What Determines Volatility?

The market is cyclical. High fluctuations come after a long hiatus. The reasons may be different:

• economic data, political turmoil, natural disasters, the effect of war, etc.;
• savvy traders who deliberately swing the market in order to make money on it.

In the first case, events cannot be predicted (i.g. a flood), which may cause high fluctuations in the market. As soon as the daily volatility reaches 10% or more, market participants might be influenced by emotions, the market gets into a panic. In such cases, beginner traders act rashly, as a consequence, it makes it even more difficult to predict the chart movement.

How the Volatility Level is Determined for Forex, Stocks, Prices, and other Markets 

The indicator is measured as a percentage or absolute value - a specific currency, the number of points on the chart, etc. 

Volatility is calculated over a period of time: day, week, month, or year. The daily period will be useful for traders who trade on short positions, and weekly and monthly - on long ones. In finance, it represents this dispersion of market prices, on an annualized basis.

It is convenient to use annual values to determine the average values of fluctuations.

Market volatility, either in stock, forex or futures, is generally defined as the distance between the maximum and minimum value of an asset for a selected period of time. 

You can measure the level of price fluctuations in the market on any trading platform using ATR (Average True Range) indicator by yourself. The ATR was developed by J. Welles Wilder and was first mentioned in his book, New Concepts in Technical Analysis Systems (in 1978).

For this, you need to:

- select the "Add indicator" function on the quotation chart,

- open Volatility Indicators,

- find and apply the Average True Range indicator through the filter.

In both, either in MT4 or in MT5, you will find the ATR indicator in the “Indicators” section within the “Navigator”  window.

The ATR line will be displayed on the screen indicating the selected period, for example, 14 days. This is the average value of the distance from the maximum to the minimum price over the last two weeks. It can be used to predict the chart movement if the market situation is stable during this period of time, and there are no visible reasons for its change.

Experience proves that the currency volatility of developed countries is lower than that of developing countries because the first group of states has taken a stable position in the market. Such currencies include the US dollar and the euro, they can have a stable, but low income. On top of that, there are two types of currency - floating and fixed. Major currencies, such as the U.S. dollar, euro, and Japanese yen are floating currencies, their values change according to how the currency trades on FX markets. While fixed currencies, on the other hand, derive value by being fixed to another currency. Most developing or emerging market economies use fixed exchange rates for their currencies, which provides exporting and importing countries more stability, and also keep interest rates low.

How to Use Volatility in Trading

High fluctuations are a good opportunity to make potentially large profits. But newcomers often make such a mistake as entering the market during high volatility. At this rate, it is easy to go into a panic and make a transaction rashly in fear of missing a chance and as a result, losing a lot. It is suggested to enter the exchange in advance when the quotes are measured, and the chart is settled down a bit. Then there is a chance to test the waters of the market, join the flow and get into the plus.

It cannot be said that volatility is good or bad. It is appropriate to understand that volatility is not always a bad thing, as it can provide entry points from which investors can take advantage. It is only one of the market functioning tools, which is wisely deployed can bring rather good profit to the pocket. 

In addition to the above, from the very first transaction to subordinate price fluctuations to your goals will not work. But together with in-depth analysis, following the main market releases, and practice, you will learn how to use volatility in your favor. Develop your analysis and trading skills with CMX Markets.