In essence, high volatility conveys higher risk because of the large pip movements. That’s why vetetan traders adjust their position size.
For instance, they might increase their standard trading amount when the market is trading quietly in a range or trending smoothly. On the other hand, they might reduce their position size if the market shows sharp and whippy price action without a clear sense of overall direction.
One of the better established ways of assessing such trading risk in order to determine what size of position is most appropriate for a particular market is by looking at the level of volatility prevailing in that market.
While high volatility trading conditions can simply refer in forex market jargon to a market that shows substantial exchange rate movements in both directions, it can also be more mathematically defined.
Estimating Forex Trading Risk Using Volatility Measures
In essence, an important factor to take into account when trading is that the risk involved in holding each position depends significantly on the amount of volatility experienced in the currency pair’s exchange rate during the time frame that the position is being held.
Volatility generally depends on the swings observed in the exchange rate for a currency pair.
It can be measured for past data by reviewing the level of past or historical volatility or also by plotting the Bollinger Bandsaround the exchange rate.
Some traders also estimate future volatility by looking at the level of implied volatility used to price options on that currency pair.
Using Implied Volatility as a Measure of Future Risk
For example, currency option traders routinely assess the future level of volatility when they determine the fair value price of a forex option.
This market driven determination of volatility that is implied in option prices that expire on a particular date in the future is commonly known as implied volatility. It will usually be expressed in annualized percentage terms.
Furthermore, since the level of implied volatility used to price options is determined by human traders, it will often display typical signs of trends and ranges, as well as support and resistance levels and other phenomena that can be used by technical analysts to forecast future implied volatility levels.
Forex traders can use the implied volatility of an option expiration series for the currency pair they are contemplating trading to determine what the market is currently expecting trading conditions in the pair to be like until that expiration date.