Choose the Best Forex Volatility Indicator
Understanding the concept of volatility and being able to detect its presence are very important aspects of Forex trading. Whilst high volatility will deter those amongst us who are risk averse, for others, it provides numerous opportunities to potentially profit from rising and falling prices. In either case, knowing how to measure volatility is crucial.
In this article, we will explain what volatility is, discuss what the best Forex volatility indicator is and demonstrate a few different options!
What Is Forex Volatility?
A key characteristic you should consider when trading currency pairs is their volatility. So, what exactly is volatility?
Volatility is a way of quantifying price variability, which is a fancy way of saying that it measures the rate at which a market moves. A volatile market is one that exhibits rapid fluctuations in price. A non-volatile or a stable market has moderate price fluctuations.
The Different Types of Volatility
To complicate matters a little further, when people in the market talk about volatility, they may be talking about slightly different things. Despite this, our general description of volatility – the rate at which a market moves – holds true. That being said, these are the various ways people may interpret volatility:
- Historical volatility – calculated from actual price changes
- Future volatility – the unknown rate at which a market will move going forward
- Forecast volatility – an estimate of future volatility
- Implied volatility – used in the pricing of options contracts
In this article, we are only really concerned with the first type of volatility on the list - historical volatility. That is because when we talk about Forex volatility in terms of economic indicators, we are referring to historical volatility. We calculate this from actual price movements that have already occurred.
Why Use a Forex Volatility Indicator?
A Forex volatility indicator helps you to gauge the state of a currency pair and to judge whether it suits your needs. If you are the kind of trader looking for a steady, quiet ride then a currency pair with a comparatively low-volatility may suit you better.
On the other hand, if your trading is short-term, or you trade in a counter-trending style, you might actively seek the more volatile markets. Going beyond the quality of determining a market's suitability, Forex volatility indicators also have more specific uses, such as:
- Judging whether the market is about to reverse
- Gauging the strength of a trend
- Identifying possible breakouts from a range-bound market.
Not all Forex volatility indicators do all of these things. In fact, different indicators measure volatility in different ways and you will find that, as a consequence, different indicators are better suited to each of these uses than others.
If you are wondering which Forex volatility indicator the MetaTrader trading platforms (MT4 and MT5) have to offer, the answer is that there are several available. The good news is that taken together, they cover all the bases mentioned above.
These indicators include:
- The Parabolic SAR indicator
- The Momentum indicator (also known as the Rate of Change)
- The Average True Range Indicator (ATR)
- The Standard Deviation indicator
The Parabolic SAR
The Parabolic SAR indicator was developed by J. Welles Wilder, a major innovator in the field of technical analysis. The indicator's name stands for 'Parabolic Stop and Reverse' and it attempts to identify good entry and exit points for trades.
It is important to note that it was designed only for trending markets and is, therefore, not effective in range-bound markets. This means that, for greatest effect, you should use the Parabolic SAR in tandem with a trend-identifying indicator.
As you can see from the GBPUSD chart above, the indicator plots curves, or parabolas, of dots on your chart. Wilder, the indicator's creator, made his name as a technical analyst in the field of commodities, but he initially trained as a mechanical engineer. We can see that this part of his background is where the usage of the term parabola began to creep in.
The parabola is a curve commonly used in many parts of classical mechanics. For example, the trajectory of a projectile is a parabolic path. The characteristic curve results from the effect of gravity decreasing the projectile's velocity. There is a similar tendency with trends. Trends can endure for extended periods, but as we all know, they do not go on forever. The driving force behind them always peters out eventually.
How Is the Parabolic SAR Calculated?
The Parabolic SAR attempts to help traders navigate volatile conditions and assist them identify potential trends. The trend is likely to stay within the arc of the curve plotted on the chart and, should the price reach the curve, it suggests that the trend may have ended.
The Parabolic SAR is calculated for a day ahead as follows:
- SAR tomorrow = SAR today + AF x (EP – SAR today)
Where:
- AF is an acceleration factor
- EP is the extreme point – the highest value so far within an uptrend, or the lowest value in a downtrend
The acceleration factor is set at an initial value of 0.02 by default. You may find that perhaps a different value works better through trial and error. The best way to perform this kind of experimentation is in a risk-free demo trading account.
Now, as the trend progresses, the acceleration factor's value changes. Each time the market reaches a new high in an uptrend, or a new low in a downtrend, we increase the AF by a step. The step is the initial value of the AF. What's more, there is an upper constraint on the value of the AF, and you specify this maximum when you add the indicator in your MetaTrader trading platform.
Depicted: Admirals MetaTrader 5 - Parabolic SAR Settings
The default value for this maximum in both MetaTrader 4 and MetaTrader 5 is 0.20, as you can see in the image above.
Using the indicator is pretty simple. The general guidelines can be summed up in these four points:
- When the SAR dots are under the current market price, it suggests an uptrend
- When the dots are above the current price, it suggests a downtrend
- Consequently, if the SAR dots cross from above to below, it indicates a buy signal
- If the dots cross from below to above, it represents a sell signal
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The Forex Momentum Indicator
Another Forex volatility indicator that comes with the MetaTrader trading platforms is the momentum indicator. It is also sometimes known as the Rate of Change indicator (or ROC). This indicator measures how quickly movement is changing.
Below, we can see the same GBPUSD chart as before, but this time with the momentum indicator plotted as a Forex volatility chart below it.
The indicator's value tells you the percentage change of the current market price, from the price a set number of periods before. Usually, the default value for the number of periods is 20. It is calculated as:
- Momentum = (current close – close N periods ago) / close N periods ago x 100
One way to think of it is as a way of gauging the power, or momentum, behind a move, hence its name. By demonstrating the strength or weakness of a trend, the indicator can be used to help identify possible reversal points.
How we achieve this is simple:
- The more positive the number, the stronger the upward trend
- The more negative the number, the stronger the downward trend
Using these two points, we can make some assumptions. As long as the magnitude of the momentum value remains large, we would expect the trend to continue. If the value begins to tail off and heads back toward 0, it may be a sign that the trend is breaking down. This gives us two general guides to the indicator:
- Crossing from a negative value to a positive value is a buy signal
- Crossing from a positive value to a negative value is a sell signal
While the momentum indicator is a straightforward measure of Forex volatility, it also measures direction, as well as the rate of change. A Forex volatility indicator that dispenses with direction and tells you purely about the magnitude of volatility is the Average True Range indicator (ATR).
Volatility Channels
Volatility channels are a type of indicator that plot Forex volatility influenced lines above and below the market price. These lines are known as channels, envelopes or bands. They widen as volatility increases and narrow as volatility decreases.
The most well-known volatility channel is the Bollinger Band - which is displayed on the chart below.
Volatility channels help traders to gauge what we would consider normal for a market, and what prices represent a divergence from the norm, whilst factoring volatility into the equation.
The channels or bands describe the outer boundaries of this normality. If the market breaks out beyond this boundary, we are alerted to an unusual occurrence, and can plan our trades accordingly. Bollinger Bands use multiples of the standard deviation to calculate how far away the bands lie from the central measure of price.
What Is Standard Deviation?
Standard deviation is a statistical measure that quantifies the variation of a set of numbers and is often used to measure Forex volatility.
A low standard deviation suggests that the numbers in the data set are close together, or less volatile. On the other hand, a high standard deviation suggests a wider variability in the numbers and, therefore, a higher level of volatility.
The Standard Deviation indicator comes as default with both MetaTrader trading platforms and is a useful way of visualising the level of volatility in a particular Forex currency pair. Below is a GBPUSD chart with the Standard Deviation indicator plotted below:
Final Thoughts
So which is the best Forex volatility indicator? It is not necessarily a case of which one is the best, but how best to use them in order to meet your needs.
Indicators in general work better when used to complement each other. For example, we mentioned earlier that the Parabolic SAR only really works effectively when the market is in a trend.
A successful strategy could potentially use the Momentum Indicator as your primary indicator, to initially establish whether this condition is met or not. The Average Directional Index (ADX) Indicator could also be used to serve this purpose.
The best way to learn how to use these indicators and, thus, which is the best Forex volatility indicator for your purposes is by practicing. Only through practicing can you start making more informed trading choices thanks to these volatility guides. Additionally, make sure to learn about how volatility protection keeps you safe from volatility risks.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of, or recommendation for, any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
