Every wondered how trading leads to high profits and higher risks? When one is ready to take risk, the opportunities are umpteen for a trader to make most of it. Thus when the volatility is high, the opportunities are more. This holds true for any market – commodity, stock or currency or even for that matter bond. One needs to understand in depth the factors which influence this high fluctuation. Currency market is the highest volume market and more so as its open round the clock through five days of the week. This helps traders across the globe to participate in the foreign exchange markets.
FX volatility is one of the greatest credit risks to the Indian corporate sector especially to the SMEs and MSMEs as it is often overlooked by them. Volatility in foreign exchange markets is due to inflation rate, interest rates, import and export levels, geopolitical stability, central bank monetary policy decisions and many other factors. Thus the necessity in managing it effectively is important in order to protect the company’s bottom line as it can lead to huge gains or losses. Thus a robust foreign exchange strategy should be in place to protect their profit margins.
Geopolitical factors like the ongoing US China trade spat are providing ground for whipsaw trades in global currencies. Even the Brexit discussion has been on the trader radar for more than 3 years now has seen many a currency move through troughs and crests during this period.
What is currency volatility?
Currency volatility is basically a percentage change in return of a currency pair over a particular period of time. The larger the number, the greater is the movement of price over a period of time. There are several ways to measure volatility and so are there different types of volatilities. What has already occurred is known as historical volatility, while what the market participants think will happen is implied volatility. For currency market perspective, especially for currency options, implied volatility is of more importance as it captures the expectations of the market, the complacent sentiment makes it low whereas when there is fear in market sentiment, the implied volatility is high.
Technical methods to measure historical volatility
Several technical tools are used to measure the currency volatility. Bollinger band helps in evaluating the volatility of any currency to formulate strategies for predicting the currency movements. Any change in the standard deviation, i.e. the difference of change in the bands measures the historical volatility. As the Bollinger bands expand, the historical volatility increases and vice versa as the bands contract, the historical volatility decreases. Average true range or ATR measures the historical volatility through the actual movements of a currency for implementing the trading strategies as it incorporates the price gaps. It basically measures the distance between any two points irrespective of the direction.
A better tool to help formulate strategy is where one understands overall risk of the currency portfolio. This is measured using Value At Risk (VaR) in which risk is described within a basket of currency pairs. To determine the risk on capital, the process of analyzing the returns of portfolio of currency pairs is essential. A change in one currency pair when measured through VaR indicates the quantum of money lost or gained with a specific movement of the portfolio.
Valuation of Currency options using implied volatility
Implied volatility is an important component of valuing options. Price of a currency option incorporates the market sentiments on how the currency will move when annualized. Each currency pair has a different implied volatility. Black Scholes option pricing model, which is widely used to price an option, uses the implied volatility as its major component apart from the strike price, expiration date of the option, interest rate of each currency and the current exchange rate. The model helps determine the probability of the underlying exchange rate.
Implied Volatility index (VIX) – a measure of market risk and investor’s sentiments. It is a real-time market index representing the expectation of the market for the coming 30 days. Research analysts, portfolio manager and investors look at VIX values for the market risk, stress and fear before taking key investment decisions.
The current implied volatility can be higher or lower than historical volatility, as both represent different time period from past to future. Generally, the implied volatility is higher than the historical volatility. So in a foreign exchange market, FX volatility is high and a seasoned trader incorporates volatility in his trading plan.
Volatility is here to stay
Instead of sulking over lost trading decisions, one should accept that currency volatility will live till markets exist. The unpredictable movement of prices in global markets makes them alive and kicking. Thus strategizing the investments and trades by incorporating this would give less shocks and one is more open to making informed investment decisions. Forex advisors at Myforexeye have the capability to formulate such strategies keeping in mind the client’s risk appetite and goals set at the start. Reviewing these goals and setting stop losses levels as required can make trading stress free.
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