For forex traders, volatility is a helpful notion that may help them understand the risk associated with trading a particular currency pair. This might help them choose an acceptable size for a trading position based on how much risk they are willing to take. Learn to evaluate risk using volatility as a criterion.
However, while communicating with other traders, you’ll need to be clear about what kind of volatility you’re talking about because the phrase is used in a variety of ways in the forex market.
Types of Volatility
Those who trade forex, currency futures, and currency options market use the term volatility in a variety of ways. These are some of them:
The term volatility, when used without any additional modifiers, is frequently used to qualitatively characterize the degree to which markets move irregularly, i.e., with large swings between highs and lows. A market that moves heavily in both directions, for example, may be described as particularly volatile by a trader.
The annualized standard deviation of price changes from the average price recorded over a period of time, on the other hand, maybe quantitatively described as historical volatility. This computed type of volatility is particularly useful for assessing the risk of trading a currency pair based on its previous performance.
When you trade forex, the term implied volatility is commonly used. Implied volatility is the annualized volatility implied in market-determined currency option pricing for a specific expiry date. Because it takes into account option traders’ predictions for future price swings, this market-determined type of volatility may be used to evaluate what the projected future risks are for a specific currency pair.
Implied volatility is not continuous and can fluctuate significantly depending on the expiration date and strike price. The implied volatility curve depicts how the amount of implied volatility fluctuates with regard to the expiry date to assist highlight this phenomenon.
The volatility smile, also known as the skew curve, depicts how implied volatility fluctuates as a function of striking price for currency options with a particular maturity date.