If there is anything a trader knows it’s that the forex market is a fickle mistress and at her core are price fluctuations. High fluctuation in prices, or what is known as volatility, can get some of us very excited and others highly nervous.
It’s important to remember that some volatility is natural. In fact, volatility is a trader’s friend, as it offers opportunities to set entry points at low prices and exit points at higher prices. The larger the degree of fluctuation, the more is the profit potential. On the other hand, the absence of volatility suggests highly stable prices, with rare opportunities to take profit and, even then, not meaningful enough.
As with most good things, there are downsides. While volatility presents opportunities, it also poses risks. These risks are well understood by traders, who take them into account in decision making and diversify their portfolio to hedge risks. These opportunities and risks are two sides of the same coin and a natural part of trading.
Having said that, there may be unnatural volatility, with prices fluctuating wildly and recording unprecedented highs and dramatic lows. Periods of high volatility pose unnaturally high risk and it may be wiser to wait for the market to stabilize a little before placing traders.
So while every trade has the possibility of either success or failure, volatility decides the magnitude of these results. Without volatility, you are at a lower risk of making a loss, but are also at a risk of making very low profits.
In isolation, price fluctuations may seem erratic. However, more often than not, prices follow a trend, which may be upward, downward or sideways. Volatility divergence refers to situations in which price movements diverge from the trendline. This typically happens when there’s an unexpected news event, geopolitical turmoil or uncertainty surrounding global economic growth. During such events, even the predictable currency pairs, which map to clear lines of support and resistance, may become choppy.
There were many such events in 2014-2015. The JPY plunged against the USD when Japan reported an unexpected shrinking of its GDP by 1.6% in November 2014. The CHF, which had been so predictable that it was considered a safe haven, became highly volatile against all major currencies in early 2015, after the Swiss National Bank unpegged the Swiss franc from the Euro. Later that year, the GBP/USD became highly erratic, with the Bank of England (BoE) waiting for the US Fed to make a rate decision before announcing a hike.
Such events result in heightened volatility in the forex market, with prices recording higher highs and lower lows than seen in the past.
Volatility divergence suggests entry and exit opportunities, as markets are typically expected to return towards the trendline over time. Volatility divergence can be identified by observing price fluctuations and comparing these with the overall movement of an indicator. It enables you to buy a commodity or currency near the bottom and/or sell near the top.
Volatility divergence can also be used to identify a weakening trend or a reversal. Most importantly, this concept helps you to reduce risk versus potential gain.
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