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.
Vincent Nyagaka is a Professional Trader, Analyst &. He has been actively engaged in market analysis for the past 7 years. He has a monthly readership of 100,000+ traders and has taught over 1,000 students since 2014. Vincent is also an experienced instructor and public speaker. Checkout Vincent’s Professional Trading Course here.