Using Volatility to Pick Forex Trades – Part 2

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VolatilityIn my previous post, I investigated a series of recent data from the three major Forex currency pairs, and concluded that without taking trend into account, whichever pair was showing the lowest relative volatility had the greatest edge.

I have now taken a deeper look into the data, and applied trend and non-comparative volatility to the equation, and the findings are interesting.

To determine the direction of the trend, I just measured the 10 period and 50 period moving averages. If both averages were rising, and the LOP closed above them both, then a condition of uptrend was assigned. The reverse process was applied to determine the downtrend condition.

To determine relative volatility, I compared the full range of each day to the 15-day average true range.

The results showed something very clear: the positive edge in trends was stronger in all three currency pairs when the volatility was relatively high. In particular, the edge following days with volatility greater than 125% of the average volatility over the past 15 days, was significantly greater.

This suggests that when pullbacks within trends turn around and resume the direction of the trend (something my HIPs and LOPs crudely indicate, which is why I used them in this study), the edge is better when the resumption of the trend is abnormally large.

Interestingly, the effect was notably weaker in the EUR/USD currency pair than it was in the USD/JPY and GBP/USD currency pairs. This is because the EUR/USD is prone to deeper and more frequent retracements within its trend movements, while the GBP/USD and USD/JPY take off more strongly and quickly when they are trending.

Another item of note in this data is that if we just look at all the candlesticks, regardless of whether they are HIPs or LOPs, for each of the three currency pairs, positive edge ratios are better when volatility is above average, and better still when volatility is above average.

Adam is a Forex trader who has worked within financial markets for over 12 years, including 6 years with Merrill Lynch. He is certified in Fund Management and Investment Management by the U.K. Chartered Institute for Securities & Investment.