The exchange rate volatility

The study of volatility is important in risk management, rates forecasts but is also a selection criterion of the exchange rates to be dealt.

In fact, according to his style and trading horizon, a stakeholder can select certain crosses more favourable to his achievement among the ones proposed by his broker.

Here are two tables that present the medium daily volatility in 2008 for 45 crosses and for the 10 more dealt on the Forex:

The different exchange rates propose a large range of volatility, so the trader can choose the ones that correspond to his trading style. To choose the crosses more favourable to his system, the stakeholder can compare these volatilities to the spreads proposed by his broker and to his trading horizon.

A scalper will probably be more selective in the choice of his exchange rates. As he does a great number of short term operations, his profits on each position are low so he will only deal with the crosses that offer volatility threshold high enough and low spreads in order to limit the impact of the transaction costs on his achievements.

A swing trader will have a wider choice of crosses because costs have less impact on his achievements. Finally, an investor, who works on long term, can afford to work all the currencies crosses, even the less volatile.

The different exchange rates volatility is not stable in time and fluctuates according to the worldwide economic situation. In a healthy climate, the volatility will generally be low but in crisis period, it can reach high thresholds like it was in 2008.

The following graph shows the evolution of the medium daily volatility of the EUR/USD from 1981 to 2008:

The crosses chosen by the traders will fluctuate with time and it will be interesting to study the evolution of several volatilities.

Another aspect of volatility is its use to define the best moment to do transactions. According to the different trading styles, the traders can wait for certain volatility thresholds to enter into action. A scalper will generally wait for high volatility threshold like the ones a pick off the European session. A swing trader may wait for volatility hollow to quietly build his position.

Certain traders even totally change their trading style according to the current volatility of the markets; some of them will use totally different systems according to the worldwide economic situation. In a healthy climate, they will build for example medium term positions whereas in a crisis climate, they will look after taking advantage of the slightest jolts of the rates by using short term and more aggressive trading systems.