Trading Forex when Volatility is High

Adam Lemon

What is Volatility?

The rate that currency pairs fluctuate over a given time period is called volatility. You will find that currency pairs move at a much faster rate over extended ranges when volatility is high. Forex generates very high levels of volatility about 30% of the time and can produce very sharp price spikes during these periods.
 

How to Trade When Volatility is High

You should always adhere to your Forex trading strategy at all times, but especially so during volatile periods. Price movements can be so rapid and vicious that you cannot allow even the slightest emotional whim to interfere with your Forex trading decisions. As a major priority, you need to control and lower your risk exposure as the pressure on you intensifies under these conditions. Unless you impose strict self-control and discipline, the sheer speed of events could overwhelm you resulting in serious financial losses.

To counter the effects of volatility, you must focus on the key elements of your Forex trading strategy such as its money management concepts, risk control benchmarks and contingency plans. For example, you should consider using tighter stops in order to reduce your risk of financial loss. You may quite rightly object that you could be stopped out quicker because of the violet price movements. However, you are still well-advised to expose even less of your fiscal budget under these conditions.

You can achieve this objective by employing smaller stops together with reduced lot sizes. You should aim to risk not more that 1% of your entire budget when Forex is volatile. You could still realize good profits because the size of your wins could be greater because of the increased price movements.

For example, assume that you are shorting an USD/YEN trade. Under normal conditions, let us assume you usually use a 100 pip stop. When conditions are volatile, you could consider using just a 60 pip stop which will still provide you with an adequate level of protection. However, should you be stopped out, then you must realize that the vicious price movements would have more than likely extended much further.

You could research and perfect this concept by bench-testing different stop values during previous periods of high Forex volatility. For each configuration you choose, you need to calculate its win/loss ratio and expectancy values so that you can compare them to others. You will eventually hone into the best stop value by utilizing this approach.

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Manage Your Risk

The first thing that you need to pay attention to its risk. For that matter, it should be the first thing that you pay attention to in any trading environment. Ultimately, if you don’t manage your risk, you will go broke trading and lose all your trading capital. That’s always going to be the first thing that you should think of when putting money to work.

If situations continue to become very volatile, then you are looking at a situation where protecting your risk becomes even more important, and therefore you should look into your trade size. For myself, one of the most effective ways I have found to protect trading capital in a volatile situation is to cut the position down. In other words, if you typically trade 0.5 lots, then you may wish to trade 0.25 lots because of the inherent risk in a market that can move very rapidly.

Understand that professional traders will be forced by risk managers to cut down their position size as well. For that matter, professional traders tend to trade with much less leverage than the retail trader. It’s not uncommon at all to see a professional trader using 1:7 leverage, instead of the 1:200 that a lot of retail traders will use. Part of this is because the professional trader has a larger account, sometimes going into the millions of dollars depending on the situation and/or bank they are working for. When you make a 5% gain, it means much more in that account than it does in a $2000 account.

The Trend Becomes Even More Important

When trading in a volatile market, the overall trend becomes much more important. While volatile markets typically denote some type of trend change, the reality is that the longer-term trend tends to be what the market pays attention to overall. Because of this, if you are in a volatile market you may wish to only trade in the direction of the longer-term trend, meaning that you need to sit on your hands occasionally. I think at this point, it’s likely that the best thing to do is wait for the larger money to come in and push in the right direction, as well as keeping your trade position smaller, because of the potential of losses.

Typically, a lot of volatility comes at the hands of fear and possible occasional headlines, but when you look at a Forex chart, most of the time they trend for years. There are times when things go back and forth rather drastically, but overall, I think that most of these moves end up being value propositions for those willing to jump into the fire. That doesn’t mean you should be overly eager; it just means that the longer-term trend still holds true for the most part. You should however have a “line in the sand” when it comes to the longer-term trend and recognize that a break down below or above that line represents a change.

Once the longer-term trend changes, it changes the overall strategy when it comes to trading, but this as a general rule should be something that is based upon weekly, if not monthly charts. While this could cause a lot of short-term pain, the reality is that eventually the longer-term trend reasserts itself most of the time.

Sometimes, It’s Better to Sit on the Sidelines

Unless there’s some type of major geopolitical or global event, the reality is that you can almost always find a pair to trade that’s much less volatile. Ultimately, a lot of traders get married to a particular currency pair, not understanding that they all operate the same. In other words, if you are typically a trader of the EUR/USD pair, then you should perhaps look to another market if it has become too volatile. Exactly what is stopping you from changing the pair and start using the EUR/CHF pair? Just step away from the overly volatile currency pair, because it’s not worth it. At the end of the day you are simply trying to profit, not become a genius on a particular currency.

Use Higher Time Frames

Another thing that you can do when things get a bit volatile is simply go to higher time frames, which will naturally make you cut down your position size. For example, you may typically trade the hourly chart and risk something along the lines of 50 pips on average. However, if you are forced to trade the daily chart, you may need to risk 120 pips on average. You still want to risk the same amount of capital per trade, so you will have to start out with a smaller position in let the market work its magic over time. This forces you to focus on the big picture and pay attention to the overall attitude of the market instead of the day-to-day noise.

Switch Off the News

You should be cautious about paying too much attention to headlines, because they don’t matter. What matters is where prices going, not what some politician in Brussels says, Donald Trump says, or anybody else. Markets are truth, and truth can be found in pricing. Beyond that, when things get too volatile you will find poor analysis much more likely, as even the best analysis can become less useful after just a few hours. You need to look at the big picture in these situations, and simply relax.

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3 Ways to Stop Your Account Blowing Up in a Wild Market

The wild movement by the Swiss Franc in 2015 wiped out a lot of Forex traders who were short of the currency. However, there were three things these unfortunate traders could have done that probably would have ensured their accounts survived to trade another day.

Let’s firstly be clear what really caused most of the wipe-outs in order to identify the potential remedies: the market moved so fast that stop losses could not be honored, and were “slipped” by huge quantities, resulting in trade exits on far worse terms than anticipated. Traders not using stop losses found themselves unable to exit trades for several minutes, at a loss of approximately 14% multiplied by whatever true leverage they were using. Most retail Forex traders use true leverage of at least 8 to 1, which would have been enough to wipe out their accounts.

What could have been done differently to prevent those wipe-outs? What can traders do now to protect themselves from being wiped out by a sudden and huge fluctuation in the market?

Use Guaranteed Stops

Some brokers offer guaranteed stops. It comes at a price, meaning that if you want a guaranteed stop, you have to pay a higher spread and/or commission on the trade. Usually, even over periods of several years, traders using guaranteed stops on every trade will come off worse than traders using normal stops which might suffer from slippage. However, guaranteed stops do provide a protection against a “black swan” move in the market.

Lessen Risk: Lower Leverage

Most brokers offer very highleverage, but you do not have to use it. There are brokers allowing position sizes of 1 penny per pip. Professional traders tend to use no more than 3 to 1, which would at least have avoided a total loss of an entire account.

Question if a Currency is Prone to a Sudden Huge Move

It must be said, even in hindsight, that there were a few voices warning that the Swiss Franc could suddenly massively rise in value. This currency was being kept artificially weak by its own central bank, and was bound to strengthen dramatically immediately as soon as the Swiss National Bank announced its abandonment of its capping policy with mere words.

Trading all the time with guaranteed stops and very low leverage is probably too much for most retail traders to reasonably bear. However, it is possible to identify any currencies that are prone to a dramatic movement following a few words from its central bank, and trade those currencies in particular with guaranteed stops or very low true leverage.

The only major global currency that is likely to meet these criteria at the time of writing is the Japanese Yen. The JPY has weakened with the encouragement of the Japanese Central Bank. Were the JPY to suddenly announce that in its view the weakening had gone far enough and should proceed no further, it might suddenly strengthen by a fairly large amount, although it would almost certainly not be close to the huge 14% move by the CHF.

Prudent traders might decide to trade certain currencies only with guaranteed stops or very low leverage, or even to avoid them altogether. Unfortunately, a sudden and devastating act of terrorism in any major city, especially in a global financial center, with a weapon of mass destruction, is something that cannot be intelligently guarded against. In any case, such an event would be likely to shut down global trade.

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Major News Releases and Forex Volatility

You will need your Forex broker to provide you with fast execution and fix spreads if you plan to trade major news releases. This is because these highly volatile events can produce rapid spike movements on the Forex market. Unfortunately, many Forex brokers are not capable of supplying price feeds that are fast or powerful enough to cope with major Forex fundamental releases. Forex becomes extremely active about the scheduled times of very important economic announcements. This is because extremely large volumes of orders are being presented for execution within a very short time frame.

As such, your own order could be overlooked because it may be swamped by this frenzy of activity. As such, your order may not even be executed until sometime after the market has surged through your selected opening price. Frequently, there may not be enough liquidity in the market to fill all the orders at the price points displayed. You must understand that this problem often happens during serious fundamental releases when Forex volatility is extremely high.

In addition, you probably detect entry and exit points for your new trade positions by depending on one or more technical indicators. However, all these tools have inherent problems handling this task. For instance, most of them do not cope very well with the violent volatility that Forex can generate because they were designed well before its birth. You must definitely take this fact into consideration should your try and trade major news events.

As such, Forex technical indicators should not be considered the holy grail of trading. Their designs tend to be more effective during times of more stable trading conditions when statistical patterns are more visible and recognizable. You will find that these tools do not perform very well in the tsunami type conditions that Forex is capable of generating during volatile periods.

If you depend on technical indicators, can you update and modify them in order that they can cope better with these violent conditions? Unless you are brilliant at mathematics, this option is not really on the table. A more feasible way forward is for you to integrate your chosen technical indicators into a complete Forex trading strategy.

In conclusion, you must become acutely aware of the difficult problems that can be created during volatile times. This is because Forex is such a powerful entity that it can render many standard trading techniques practically redundant.

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Volatility Clusters

The pioneering work of Benoit Mandelbrot identified a prevalent phenomenon in financial markets: volatility clustering. What this means is that when volatility is relatively low, it is more likely than not to remain low the next day, and the same follows then volatility is relatively high. Of course, traders have understood this phenomenon instinctively for decades before it was proven scientifically. Traders have tended to exploit this by watching for a sudden explosion of volatility in a quiet financial instrument – traditionally, a breakout – and getting in on the move and hanging on until the volatility really starts to die down again.

You might ask whether this phenomenon can be observed in Forex. Let’s conducts a test of two major currency pairs between 2002 and 2017: the EUR/USD and the GBP/USD, and firstly measure the autocorrelation of the daily price movements. A result of 1 would be a perfect positive correlation, with -1 being a perfectly negative correlation. The results were:

EUR/USD: -0.03

GBP/USD: 0.02

This suggests that whether the price moves up or down today can tell you almost nothing, by itself, about the direction it will move tomorrow. However, if we use absolute values and therefore simply measure whether the size of today’s price movement tells us anything about the probable size of tomorrow’s movement – whether up or down – we get some markedly different correlation coefficients for the two currency pairs using the same data and same period:

EUR/USD: 0.09

GBP/USD: 0.14

This data suggests that while the effect might be relatively small, it exists. How can it be used practically to help with trading?

When you see a sudden price movement that is relatively very large, keep in mind that another large movement is more likely to happen today. This means that you should widen your “normal” stops considerably. It also means that if you are long, you should not panic at a strong pullback, and if you are short, you should be going for more than just a few pips.

Don’t forget that the “real” commission you pay by way of the spread goes down as volatility goes up.

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Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.
Learn more from Adam in his free lessons at FX Academy

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