How Does Volatility Affect the Forex Markets?

Foreign exchange markets, like all other financial markets in the world, are affected by volatility to a great extent. On some days, trading can be a bit of a “bore” – as volatility is low. Alternatively, on other days, volatility could be high – and therefore prices in the FX world could fluctuate wildly.

But what actually is volatility, and who creates it? Furthermore, how do we predict volatility, and are there times where volatility is known to be higher than others?

Let’s take a look at the answers to these questions.

What is Volatility?

Essentially, volatility is a gauge of the degree to which prices are changing. For example, let’s take a currency pair – the EUR/USD – and see how volatility might appear.

  • Day One: EUR/USD trades between 1.3000 and 1.3100
  • Day Two: EUR/USD trades between 1.3000 and 1.3020

As you can see, the EUR/USD currency pair has traded in a 100 pip range on the first day, and then a 20 pip range on the second day. Which is the more volatile day? Obviously, the first day is. This illustrates exactly what volatility is – in its most basic context.

However, there is also one other consideration that volatility calculations take into account. That is – how quickly the price changes. For example, going back to day one – if the currency pair gradually rose between 8 am and 5 pm from 1.3000 to 1.3100 – this wouldn’t be particularly volatile. However, if it traded from 1.3000 to 1.3030 in the first 5 hours of the day, and then suddenly went from 1.3030 to 1.3100 in the last hour of the day – this would indicate a high level of volatility.

Hopefully, this illustrates how volatility is created, and why it has important implications for traders in all financial markets.

How to Predict Volatility

Volatility is somewhat difficult to predict because even the slightest piece of news or rumor in the market can cause currency pair prices to escalate or fall dramatically. Hence – it is best simply to not try to put too much weight on predicting where volatility will go.

However, there are times where volatility is known to be higher on average than others. One of these times is when a major piece of news is about to be released to the market. Take, for example – the non-farm payroll release which comes out on the first Friday of every month. Before this data piece is released, the markets usually see a spike in volatility as last minute trades are placed before the announcement. In this manner – you could actually profit from increased volatility if you are on the right side of the trade.