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Thursday March 19, 2009 - 14:33:57 GMT
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Forex market: How to adjust to a return to volatility

Volatility has come back to the forex market with a vengeance after seeing it trend down in price swings over the past several years. It feels like the 1980s again when large daily swings and sharp trend moves were more the norm. The advent of electronic trading and price transparency as well as the introduction of the euro among other factors had led to a reduction in volatility that favored the market makers, where there were limits to risk on an intra-day basis. Large swings, such as after a key economic report, were more the exception than the norm.

All of that has changed. The global financial and economic crises have seen the forex market experience a sharp increase in volatility. Although I have not quantified it, the price action suggests reduced participation and reduced risk taking have contributed to the increase in volatility. There are fewer players in the market with some hedge funds and other players falling victim to the financial meltdown experienced late last year. Those still in the market have been forced to reduce leverage. Banks have been forced to pullback on taking risk. This has probably made it more difficult for the market to absorb large orders during periods when liquidity drops. The volatility has forced traders to take a more defensive approach to protect capital.

The market has thus been forced to shift gears. There are clearly opportunities to make large profits in this environment but also risks where one can get wiped out on a surprise move in the market. Examples of surprises were the recent move by the Swiss National Bank to intervene to weaken the CHF (vs. the EUR) and the FOMC decision for the Fed to undertake quantitative easing. In both cases, the markets reacted violently with large gaps and large swings, especially by recent historic standards. For example, the EUR/USD was trading at 1.3105 just prior to the FOMC announcement and it closed around its high (1.3499). This represents a 3% swing in less than two hours. For the day, the EUR/USD experienced a 3.9% swing from low-high. This may not seem like a large move for equity traders but in a leveraged market such as Forex, it is a mammoth move.

The question is then, how does one approach trading this market? Prior to the increase in volatility, a lot of strategies were based on trading ranges as the dollar seemed to spend more time ranging than trending. With risks contained, many favored this approach as there seemed to be limits on both sides. In the current environment, daily ranges have expanded and tend to overshoot more often than not.  This argues for leaving larger stops and lowering leverage to account for the volatility. Larger stops do not guarantee your position will get stopped but at least provide more protection than tight stops, which have a greater risk of being triggered. In addition, expect more “slippage” from your bank or broker due to volatility in pricing in the interbank market.

The risks in the market also argue to be aware of the fundamentals, especially in a world where government interventions in the free market have increased significantly. The two large moves over the past week have been triggered by fundamental news (i.e. SNB and Fed) so being aware of fundamentals is critical if you don’t want to get blindsided. Some technicians will argue that everything is factored into the prices. However, there is no way technicals can price in future fundamental headlines so an awareness of the fundamentals, even for a technical trader, is important.

To sum up, the world has changed. Everything goes in cycles and this one has seen a return to volatility. This means it is no longer business as usual and one has to keep in mind the importance of protecting capital so you can live to tradeanother day. This argues for defense as well as offense when employing trading strategies. It also argues for being aware of fundamentals in a world economy where government actions are playing a key role. Stay disciplined. Live to trade another day!

Jay Meisler

Jay Meisler is a co-founder of www.global-view.com, the forex discussion site and co-author of Forex Essentials in 15 Trades, The Global-View Guide to Successful Currency Trading



 

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