Measuring volatility in forex gives the retail traders the ability to spot early changes in the market and identify profitable trades.
As forex traders, we need volatility in order to make money from price movements. Without volatility in forex, market is dead and chances to profit are close to zero.
This is why we only trade when volatility is high and we stay away from the market when volatility is down.
There are many ways to measure the volatility in forex. We can either use technical indicators, such as ATR (Average True Range) and Moving Averages, or simply calculate the historical volatility ourselves using Excel spreadsheets.
In this article, I will show you:
How to measure historical volatility in forex using Excel and
How to calculate your stop loss and target using ATR percentage.
Let’s get started!
What is Volatility?
Volatility is a statistical measure of the dispersion of return for a given asset or security. It refers to the amount of uncertainty or risk related to the size of changes in an asset’s value.
A higher volatility means that an asset’s value can potentially be spread out over a larger range of values. This means the price of the asset can change dramatically over a short time period in either direction.
A lower volatility means that an asset’s value does not fluctuate dramatically, and tends to be more steady.
What Causes High Volatility in Forex?
In our modern economy, currencies are easily affected by so many factors, such as economic data release, geopolitical conflicts, natural disasters, and big social events that cause high volatility in forex and other financial markets as well.
The Importance of Volatility in Forex
The ATR calculation tells us whether short term opportunities may be about to occur, clues as to how we should be seeking to manage our risk and whether we should be short term trading versus long term trading.
Remember that the ATR calculation is a historic volatility calculation because we are using historical data to gauge clues on how the forex market would move in the nearest future.
As forex traders, we want to go where the money is and change our trading style according to the market conditions.
If there are no short term opportunities (low volatility), we choose a long term trading style (swing and position trading). This happens 80% of the time.
If the volatility in forex rises, we go from long term trading to short term trading style (intraday/ day trading) to profit from short term opportunities.
Another important thing about ATR is that it helps us calculating our stop loss and target based on the values of ATR percentage. This is important because once we know the average daily range of an asset, we can put our stop-loss order a few pips away from it so we don’t get stopped out.
How to Calculate ATR%
The Average True Range (ATR) of an asset is a historical volatility indicator that calculates the average of a number of previous True Range Values.
The True Range (TR) of an asset over a certain period (t) can be defined as follows:
The ATR and TR values allow us to understand historical volatility, and when we compare these values across various periods we can gauge how the volatility of an asset has changed with time.
By understanding ATR as a historical volatility indicator, we can use is to appreciate the trading opportunities inherent in the asset and the risk that come with it.
In this example, we calculate rolling one-day ATRs for the EUR/USD and compare averages of these rolling ATRs over different periods in time.
Step 1 – Getting the Historical Data
To begin with, we need to download EUR/USD historical data set:
– Go to https://www.investing.com/currencies/streaming-forex-rates-majors
– Select EUR/USD pair from the list.
– This will direct you to the summary page for the EUR/USD Euro US Dollar.
– Now navigate to the historical data page by clicking on “historical data” under General:
On the historical data page, we can choose the time frame in which we want to extract prices from, as well as the starting and ending dates. In this example, we will use daily data from the 3rd of January 2000 to the 21st of November 2018.
– Change the start date to “3 Jan 2000”
– Change the end date to “21 Nov 2018”
– Select “daily” as the time frame.
– Click “Download Data” to download the spreadsheet.
Step 2 – Arranging the Data in Microsoft Excel
The screenshot below shows what the excel spreadsheet should look like when opened:
If the “Date” column is filled with # symbols as in the screenshot, the column width needs to be adjusted so we can see the values in full.
Click on column A and navigate to Home/Format/AutoFit Column Width.
For Average True Range analysis, we only need data for the High, Low and Open prices of each day. Delete columns B and F.
Step 3 – True Range and Average True Range Calculations
In this step, we will create two columns with TR and ATR data respectively. The ATR will be calculated on a rolling one-day basis.
True Range Calculation
We will begin with the True Range column:
– Select cell E1 and type “True Range” to head the column and press Enter.
The next stage involves calculating the true range:
– Select cell E2 and type “=C2-D2” and Press Enter.
Next, we copy down the formula we just applied to cell E2, down to E4930 (the earliest date in our dataset).
Average True Range Calculation
Now we have calculated the True Range of each of our trading days, we move on to calculating the rolling one-day ATR at each period (day):
– Select cell F1 and type “ATR”, heading a column that will contain our one-day rolling ATR and Press Enter.
– Select cell F2 and type “((Sum(E2:E3)/2)/B3” and Press Enter.
– We are now going to copy this formula down to the entire F column.
– Change the numbers in Column F to display itself in percentage format with 2 decimal places and Press OK.
This changes all the ATR values we have just calculated to display themselves in terms of percentages. Notice how cell F4930 has an error “#DIV/0!”
This is because the ATR calculation within this cell relies on data from the previous trading day, which we do not have. Before we proceed, delete the contents of this cell.
Our ATR values show an average of two-day trading ranges expressed as a percentage. This allows us to track changes in the one-day ATR on a rolling basis through the historical period analyzed.
Changes of ATR over time
To see how the one-day ATR of the EUR/USD pair has evolved over time, we are now going to find some averages of these rolling one-day ATRs over various time horizons:
– 5 Days.
– 20 Days.
– 60 Days.
– 250 Days (1 Year).
– 750 Days (3 Years).
– 1250 Days (5 Years).
– 2500 Days (10 Years).
– 5000 Days (20 Years).
– 12500 Days (50 Years).
These cells represent the time horizons, expressed in days, over which we will analyze the average one-day rolling ATRs.
To find the average ATR over these periods takes the following steps:
– I4 and type “=average(F2:F6)”.
– J4 and type “=average(F2:F21)”.
– K4 and type “=average(F2:F61)”.
– L4 and type “=average(F2:F251)”.
– M4 and type “=average(F2:F751)”.
– N4 and type “=average(F2:F1251)”.
– O4 and type “=average(F2:F2501)”.
– P4 and type “=average(F2:F5001)”.
– Q4 and type “=average(F2:F12501)”.
This gives us an idea of the changes in the volatility of the EUR/USD pair. We can see that over the last 50 years there has been a general tendency towards less and less daily volatility in forex.
This reiterates the fact that day trading opportunities are typically minimal, and we must wait for periods of higher volatility to take advantage of day trading. Most of the time, we require longer periods of time to see enough price movement to make our trades worthwhile.
Volatility in forex helps us identify when we adopt a long term trading style and when we switch to shorter-term trading, such as day and intra-day trading strategies.
We can do this to any asset and for any time frame we want. We will notice that when we increase the time frame of the asset, the ATR percentage increase and thus making more profit.
Calculate your Stop Loss and Target
We are going to use the ATR percentage we calculated earlier to find our stop loss and target prices. Let’s assume that we want to execute a Buy order on EUR/USD at 1.14000 price.
To figure out where to put our stop loss, we simply use the Daily ATR percentage to calculate the stop-loss price:
Entry Price: 1.14000
We simply multiply the ATR percentage by the entry price:
Stop-loss = 0.74% x 1.14000 = 0.008436
Since we entered a BUY order, we need to subtract 0.008436 from our entry price to find the stop-loss price:
Stop Loss = 1.14000-0.008436 = 1.13156
This is our stop-loss price.
Now, let’s assume we enter a SELL order at the same entry price 1.14000, our stop loss will be:
Stop Loss = 1.14000+0.008436 = 1.14843
This is our stop-loss price.
When using ATR percentage to calculate stop-loss orders, we reduce our chances of getting hit and stop out by market movements.
For our target, we multiply the stop loss by 3 (using 1:3 risk-to-reward ratio):
Target = Stop Loss x 3 = 0.008436 x 3 = 0.02530
For a Buy order:
Target = Entry Price + 0.02530 = 1.14000 + 0.02530 = 1.16530
For a Sell order:
Target = Entry Price – 0.02530 = 1.14000 – 0.02530 = 1.11470
Before you go, make sure you download the EUR/USD ATR Excel spreadsheet.
Also, read about the 3 methods to calculate and place your stop loss in Forex.
Being able to calculate the volatility in forex will improve your trading performance by helping you choose strategic stop losses and take profits.
Clearly, when it comes to placing stop-loss orders, a large number of forex traders have a hard time choosing the right number of pips to risk in each trade.
This calculation will not only help you place smart stops but also protects you from placing them within the daily range. Therefore, your stops won’t be triggered by mistake and make you lose money before the market goes your way.
Remember that the volatility in forex is a double edged sword. With high volatility comes great trading opportunities and more risks. To minimize your risks when volatility increases, you must have a strict risk management strategy to help you protect your capital from the high volatility in forex.