Introduction
This article explores the concepts of volatility. We use the plural here because there are actually multiple types of volatility. And you may be surprised to learn that the type most commonly used by traders is actually less critical to future changes in prices than its lesser-known counterpart. Indeed, the disparity in access to information creates a practical gap in how market fluctuations are analysed by retail participants compared with institutional players.
What is volatility
In essence, volatility is the rate of change. In the foreign exchange market, volatility refers to how much and how quickly a currency’s exchange rate changes over a specific period. Volatility does not indicate the direction of the market. It indicates the level of moves (fluctuations) of an exchange rate. When a specific Forex pair is said to be highly volatile, it means that this pair often moves rapidly and travels a wide range of values in a relatively short time. In other words, the price swings can be massive, sharp and unexpected. Conversely, a low-volatility pair is one whose rate changes slowly, and often stays within a narrow, predictable range with minimal sudden spikes. Volatility can be expressed as an annualised percentage, a fraction, or in absolute terms like pips.
Why traders love and hate volatility
Besides the fact that the Forex market is the largest and one of the most liquid markets in the world, it is also very volatile. And this is definitely one of the main reasons why so many people find Forex trading so attractive. High volatility offers traders more opportunities to make quick and (sometimes) large profits. However, it also increases the chances of loss. In other words, volatility is a double-edged sword. Some traders (especially day-traders and scalpers) love it for rapid profit opportunities, as quick moves can result in substantial pip gains in mere seconds or minutes. Other traders (particularly position and swing traders) hate it due to emotional pressure, wider broker spreads, and the high risk of sudden stop-outs.
Types of volatility
Volatility comes in two forms: past and future. Past, historical, or realised volatility is built from actual price data over a specific stretch of time (for example, over the last 30 days) and shows how erratic a currency pair has been over that period. This type of volatility is objective and easily calculated. Future, expected, or implied volatility represents the market’s current expectation of future price fluctuations. Implied volatility is calculated based on the pricing of option contracts, which reflect how investors hedge against future market swings and at what cost.
Usually, it is the historical volatility that gets most attention because it is relatively easy to calculate. Elev8, a global Contract for Difference (CFD) broker, notes that retail traders tend to focus almost exclusively on historical volatility. The reason is quite straightforward: retail trading platforms measure historical volatility in real time through a multitude of embedded technical indicators, and traders are used to monitor it closely. However, it is the implied volatility that is more important from a trader’s perspective. Unfortunately, it gets less attention because it is more difficult to calculate, and free tools for calculating it are not readily available to the public.
Measuring historical volatility (and what it tells us)
Retail trading platforms offer several free, built-in technical indicators to gauge historical volatility. We will have a look at the four most common.
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Bollinger Bands (BB)
Created by John Bollinger in 1983, this indicator consists of a middle line (usually a 20-period simple moving average) and two outer bands. The outer bands are plotted two standard deviations away from the middle line.
When the bands narrow, it means volatility is low, and some kind of breakout (sharp move) could be coming. When the bands widen, volatility runs high, and price changes capture a wide range. If the price spikes outside the bands, it signals an extreme move, which is unlikely to last, prompting traders to bet on a return to normal.
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Average True Range (ATR)
The ATR measures the average range between the high and low prices of a currency pair over a set number of periods (usually 14). Thus, a rising ATR means the daily trading ranges are expanding (volatility is increasing). Likewise, a falling ATR means the market is calming down. Traders use the ATR to set realistic take-profit targets and stop-loss distances.
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Average Directional Index (ADX)
While the ADX is primarily a trend-strength indicator ranging from 0 to 100, it serves as a useful proxy for volatility. ADX line rising above 20 or 25 is a confirmation that a strong trend is forming. Strong, sustained trends are almost always accompanied by expanding volatility.
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Commodity Channel Index (CCI)
The CCI measures the current price level relative to an average price level over a given period. When the CCI shows extreme readings (above +100 or below -100), it indicates that price volatility is accelerating rapidly, signalling that the currency pair is entering an overextended state.
Measuring implied volatility (and what it tells us)
While historical volatility indicators are useful for chart analysis, professional fund managers look at implied volatility (IV) to price risk more accurately. To understand how the market is pricing upcoming risk, we can look at a real-world snapshot of the euro (EURUSD) options market:
Euro implied volatility term structure
The term structure shows how implied volatility changes across different option expiration dates (tenors) at the current market price (at-the-money, or ATM):
Source: Refinitiv
A 3M ATM IV of 5.37% implies the market expects a relatively calm environment for EURUSD over the next quarter.
To convert this percentage into an expected daily move, use the ‘square root of time’ rule:
Daily expected move ≈ 5.37% / √252 ≈ 0.34%
On the spot EURUSD rate near 1.13800, a 0.34% move translates to roughly 39 pips per day of expected movement. This signals a quiet, range-bound market.
As you can see, the volatility curve rises smoothly from 2W (5.68%) up to 2Y (6.58%). This is a normal market pattern. It suggests that the market is calm right now and can forecast the near future with a relative degree of certainty. However, further into the future, implied volatility increases as traders expect greater uncertainty, such as central bank interest rate decisions, macroeconomic shifts, or geopolitical news.
Notice the brief spike in overnight IV at 6.93% (much higher than the 1W-2W average of ~5.89%). Elev8 broker point out that such sharp overnight spikes typically signal an immediate, high-impact catalyst occurring within 24 hours (such as a major CPI release or central bank announcement) before market expectations settle back toward baseline levels.
Rules for surviving the volatility
If you want to survive and profit from volatile FX markets, consider incorporating five key rules into your trading plan.
- Adjust your leverage and/or position size. High volatility increases your gains but can also increase your losses. Lower your leverage or open smaller positions when volatility rises.
- Diversify, don’t concentrate. Never risk all your capital on a single currency pair, especially when the market is chaotic.
- Aim wider. When volatility rises, widen your stop loss and take profit levels to prevent getting prematurely ‘stopped out’ by market moves. Allow your position enough room to capture the larger price swings.
- Use multi-timeframe analysis. Always keep the big picture in mind. Use weekly or daily charts to identify strong key levels, then zoom into hourly charts to manage your entry points.
- Patience is also a position. Sometimes, the best trade is no trade. If you are uncertain about a massive market swing, step aside. Capital preservation should always be your first priority.
Disclaimer: This article does not contain or constitute investment advice or recommendations and does not consider your investment objectives, financial situation, or needs. Any actions taken based on this content are at your sole discretion and risk—Elev8 does not accept any liability for any resulting losses or consequences.
Elev8 is a global broker that takes trading to a new level. Elev8 provides traders with an ecosystem designed to meet their needs, featuring a wide range of instruments, analytical and educational tools, integrated AI solutions, and responsive customer support. As a socially responsible broker, Elev8 funds various charitable projects and humanitarian efforts worldwide.
This article was written by IL Contributors at investinglive.com.