Many forex traders adjust their position size depending upon the risk that they perceive exists in trading a particular currency pair or time frame.
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.
The Risk Reversal as an Estimate of Directional Bias in a Market
One interesting aspect of implied volatility for currency options is that the implied volatility for out of the money puts of a particular sensitively to the spot rate or “Delta” will often be different for the implied volatility for out of the money calls of the same Delta.
This difference reflects a directional bias in the market that either favors high option strike prices in the case of an upwards trend or low strikes in the case of a down trend.
This sentiment indicator can be assessed by observing the so-called risk reversal that usually quotes 25 delta puts versus 25 delta calls.
Historical Volatility Reflects Past Trading Risk
On the other hand, some traders who might be less familiar with the currency option market and how to use implied volatility may instead wish to use a mathematically calculated quantity that can be displayed as a technical indicator under the price action for a particular currency pair.
Commonly known as historical volatility, this indicator represents the annualized standard deviation of price movements observed over some period of time. Like implied volatility, it will usually be expressed as a percentage.
Bollinger Bands Help Traders Assess Market Volatility Rapidly
Bollinger Bands are another popular measure of past volatility. They are based on a certain number of standard deviations being plotted around a moving average that is usually superimposed over the price action for a currency pair.
Since these bands tend to widen during volatile periods and narrow during calmer trading conditions, they can be used by forex traders to assess trading risk quickly and visually for the particular currency pair under consideration.