How to Use a Forex Volatility Indicator and what is It?

Firstly, what is Forex? I know many people ask that question when they initially stumble across the mysterious yet appealing world of trading. To kick things off, Forex trading which is also known as foreign exchange or FX trading, is when one currency gets converted into another. That is the simplest way to put it. Unfortunately, forex trading isn’t as simple as its description. It is one of the biggest and most actively traded markets in the world, with an estimated trading volume of $5 trillion PER DAY!

Many people overlook the significance of the forex market and how important it is to the running of the world. Currencies are needed because when it comes to conducting foreign trade and business, currencies need to be converted. For example, if you’re living in the U.K. and you want to buy a watch from a company in Switzerland, you would then have to convert your Pound Sterling into Swiss Francs. Another simple example of how important the currency markets are is when you travel to a different part of the world, you need to convert your currency to the country that you’re traveling to.

What is Forex Volatility

Whilst a lot of forex trading is done for practical purposes like the examples I outlined above, a large proportion of trading is done by traders for the sole purpose of making a profit. The sheer volume and scale of the forex markets can cause some currencies to become extremely volatile. This forex volatility is what traders crave, as it can mean greater profits. But the downside is that it also increases risk. When it comes to volatility, it can be a traders best friend but it can also be their worst nightmare because it can cause a currency pair to become and unstable and subject to major price swings, which can obliterate a trading account.

How to Use Volatility

But do not despair, because there are tools out there that can help you measure forex volatility in the markets, and help you get a better understanding of which way a currency is likely to head. Ask a trader what indicators they use when they trade, and you’ll likely hear a volatility indicator. Now you’re probably asking yourself “what is a volatility indicator?”. Volatility is the amount of uncertainty or risk tied to an asset in the market, and in this case the asset is forex. The simplest way to explain volatility is the higher the volatility, the higher the risk, but more risk means more returns or profits.

Thankfully there are indicators out there that can measure volatility, and some of the best indicators are the likes of: ATR (Average True Range), Bollinger Bands and the Volatility Index. My personal favourite volatility indicator are the Bollinger Bands. The bands measure two standard deviations above and below a 20-day average, and then plot lines which represent these levels on a chart along with a line in the middle of the bands that displays a 20-day moving average. When these bands begin to widen and get larger, this signifies increased market volatility, and alternatively narrowing of the bands can mean decreased market volatility. You’ll notice sometimes that when a candle touches the upper or lower band, it quite often means there could be a reversal heading soon.

In summary, forex volatility indicators are a great tool to help traders navigate their way through the forex markets, but traders should be aware that there can be a lot of risk involved they shouldn’t risk more than what they can afford to lose.