Volatility describes the level of price fluctuation in a currency pair. Greater volatility indicates a greater level of uncertainty in market expectations.
Volatility is a measure of the amount by which price fluctuates over a given period. In forex trading, it measures how large the upswings and downswings are for a particular currency pair.
When a currency’s price fluctuates wildly up and down, it is said to have high volatility. When a currency pair does not fluctuate as much, it is said to have low volatility.
It’s important to note how volatile a currency pair is before opening a trade. Volatility should always be taken into consideration when choosing your position size and stop loss level.
In finance, volatility (usually denoted by σ) is the degree of variation of a trading price series over time, usually measured by the standard deviation of logarithmic returns.
Historic volatility measures a time series of past market prices. Implied volatility looks forward in time, being derived from the market price of a market-traded derivative (in particular, an option).
Importance of Volatility for investors
Investors care about volatility for at least eight reasons:
- The wider the swings in an investment’s price, the harder emotionally it is to not worry;
- Price volatility of a trading instrument can define position sizing in a portfolio;
- When certain cash flows from selling a security are needed at a specific future date, higher volatility means a greater chance of a shortfall;
- Higher volatility of returns while saving for retirement results in a wider distribution of possible final portfolio values;
- Higher volatility of return when retired gives withdrawals a larger permanent impact on the portfolio’s value;
- Price volatility presents opportunities to buy assets cheaply and sell when overpriced;
- Portfolio volatility has a negative impact on the compound annual growth rate (CAGR) of that portfolio
- Volatility affects the pricing of options, being a parameter of the Black–Scholes model.
In today’s markets, it is also possible to trade volatility directly, through the use of derivative securities such as options and variance swaps.