Using a Volatility Indicator for Forex Trading
This article will provide you with everything you need to know about Volatility Indicators for Forex trading. You will learn about volatility in general, the Parabolic SAR, the Momentum Indicator, and more. Additionally, you will find out how to use these indicators with practical examples, that guide you through every step involved.
Volatility in Trading
Trading Forex is not just about price. That is not to say that price isn't important, but there are other elements to consider when planning a trade. For example, do the various characteristics of the FX currency pair in question suit your trading style?
What is Volatility?
A key characteristic you should consider is volatility. Now, what exactly is volatility? Volatility is a way of quantifying price variability, which is a fancy way of saying that volatility 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.
Types of Volatility
These conditions can be in a state of flux themselves, of course. But there is nothing to say that a quiet market has to remain that way. 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 – a term used in the options market.
The pricing of options is a huge subject, and we won't go into it beyond the barest detail here. The value of an option is influenced by the volatility of a market. Theoretical models using forecast volatilities often produce results that differ from actual traded options prices. Using the price of an option in the market, you can work backwards to calculate an implied volatility.
The reason that we are mentioning options here is this: a widely quoted measure of market volatility, the CBOE's Volatility Index (or VIX) uses volatilities implied by options prices as its foundation. The VIX is a guide to the stock market. If you are looking for a Forex volatility index, there are also currency-related indices available. Having introduced these specific types of volatility, let's try and simplify things.
So here's the good news: we are only really concerned with the first type of volatility on the list. That is because when we talk about volatility in terms of economic indicators, we are referring to historical volatility. We calculate this from actual price movements that have already occurred.
What's The Benefit of This to You?
A volatility indicator helps you to gauge the state of a market, and in a general sense, to judge whether it suits your needs. You see, if you're the kind of trader looking for a steady, quiet ride, a low-volatility market may suit you better. On the other hand: if your trading is short-term, or you trade in a counter-trending style, you probably want a bit of a price chop. In this scenario, you might actively seek more volatile markets. Going beyond this usage of determining a market's suitability, volatility indicators also have more specific uses.
The various uses include:
- Judging whether the market is about to reverse
- Gauging the strength of a trend
- Identifying possible breakouts from a range-bound market.
But that's just part of the story. Not all forex volatility indicators do all these things. In fact, different indicators measure volatility in different ways, and you'll find that, as a consequence, there is one indicator that is best-suited to each of these uses. If you're wondering which Forex volatility indicator MetaTrader 4 (MT4) has to offer, the answer is, 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)
- Volatility channels
- The Average True Range Indicator (ATR)
Depicted: MetaTrader 4 - USDJPY Daily Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
What is 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. It's important to note that it was designed only for trending markets and is, therefore, not effective in range-bound markets.
What does this mean? Well, it means you really have to use this one in tandem with a trend-identifying indicator. As you can see from the daily USD/JPY chart above, the indicator plots a parabola-like curve of dots on your chart. What is a parabola? A parabola is a U-shaped curve. Now, J. Welles Wilder made his name as a technical analyst in the field of commodities, but he initially trained as an 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?
This indicator attempts to describe that behaviour. It says that the trend is likely to stay within the arc of the curve plotted on the chart. 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)
- 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 customarily set at an initial value of 0.02. You may find that a different value works better through trial and error though. The best way to perform this kind of experimentation is in a risk-free trading environment, which is available through a 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 MT4.
Source: MetaTrader 4 - Setting up the Parabolic SAR parameters
The default value for this maximum in MetaTrader 4 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
Forex Momentum Indicator for MT4
Depicted: MetaTrader 4 - USDJPY Daily Chart - Momentum Indicator - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
Another volatility indicator that comes with MetaTrader 4 is the simply-named momentum indicator. It is also known as the rate of change indicator (or ROC). As its name suggests, it measures how quickly movement is changing. The image above is the same daily USD/JPY chart from before, but this time with the momentum indicator plotted as a Forex volatility chart below it.
Its value tells you the percentage change of the current market price, from the price a set number of periods prior. Usually, the default value for the number of periods is 20. It's 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 behind a move. This is why it is known as the momentum indicator. All fairly straightforward so far, but how can we use it? The indicator gauges the strength or weakness of a trend, thus identifying 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 volatility, it does also measure direction, as well as the rate of change. A Forex volatility meter that dispenses with direction and tells you purely about the magnitude of volatility is the Average True Range indicator (or ATR).
Volatility channels are a type of indicator that plot volatility-related lines above and below the market. These lines are variously 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, though the Keltner Channel Indicator is another effective type as well.
Bollinger bands come as a standard indicator with MetaTrader 4. But if you want a more comprehensive choice of volatility channels, you should consider installing the MetaTrader 4 Supreme Edition plugin. MT4 Supreme Edition offers the aforementioned Keltner channel indicator, alongside an impressive bundle of other helpful tools.
Volatility channels help to gauge what we would consider normal for a market, and which 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 a Standard Deviation?
A standard deviation is a statistical measure that quantifies the variation of a set of numbers. A low standard deviation suggests that the numbers in the data set are close together. A high standard deviation suggests a wider variability in the numbers. The more volatile a market, the wider the variability of prices will be in a certain period, and consequently, the higher the standard deviation.
A Summary of the Forex Volatility Indicator
So which is the best Forex volatility indicator? It isn't 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.
You could perhaps use the Momentum Indicator as your primary indicator, to initially establish whether this condition is met or not. The Average Directional Index (or ADX) Indicator could also be used to serve this purpose.
Here's the good news: with a bit of practice, you can 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 solicitation 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.