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A beginner’s guide to understanding volatility in the financial markets

As a trader, or even as someone who is interested in the financial markets, you might have come across the term volatility. Volatility in the financial markets is considered to be both a blessing and a curse for traders. But the bottom line is the fact that traders can't live without volatility and you can't really trade without volatility.

Volatility defined

In the simplest of terms, many traders have an understanding of what volatility is all about. When one talks about volatility, the first thing that comes to their mind is the choppy markets or large price swings. This basic concept of volatility is rather accurate.

The traditional definition of volatility is that it is a measure of the degree of price movement in a financial asset. When one talks about volatility, it simply means that prices can move significantly from their current prices. It is important to note that volatility does not signify the trend or the direction of the movement.

Therefore, volatility simply means dot the prices of the financial asset are moving strongly.

Although the term volatility is widely used, there are two main measures.

  • Historical volatility: Historical volatility, as the name suggests measures the stock price movement based on its past or historical prices. Historical volatility measures how active the financial asset yes over a certain period of time. To get the historical volatility, the most commonly used approach is to take the daily end of day prices and calculate its percentage change this is then averaged over the given period of time and expressed as an annualized percentage. Historical volatility also goes by other terms such as actual volatility or realized volatility. The most common measures of historical volatility are 10 day volatility, 20, 30. Some long term traders might also prefer to make use of 60, 180, 360 day volatility as well.
  • Implied volatility: Implied volatility on the other hand measures the current volatility of the financial asset with the option price serving as an input. The value of an option consists of several components such as the strike price, the expiration date, the current price, interest rates and so on. Traders in general are able to calculate the implied volatility when they know the above set of functions. In order to derive the implied volatility, it is of course important that traders look at an option pricing model.

Difference between historical volatility an implied volatility

in the previous section, we have defined the two types of volatility's that are widely used in the financial markets. As you notice, both historical volatility and implied volatility are somewhat closely interrelated.

The main difference between historical volatility and implied volatility, as the name suggests is the fact that historical volatility is based on the past observed prices. Whereas implied volatility tells you the future expected volatility of the instrument.

When the implied volatility is high, it means that the market expects the instrument, whether it is a stock or forex to continue to be volatile which in other words means that it would continue to make large moves in the markets. On the other hand, low implied volatility simply means that the market expects the instrument to behave less erratic or in technical trading terms, trade flat.

It is important to know that implied volatility continues to change over a period of time.

How can forex traders make use of implied volatility?

To put it at the very simple terms, when implied volatility of a forex currency pair rises, it means that the market expects that currency pair to trade rather erratically. In other words, that currency pair might represent opportunities for trading in order to capture the big swings in the prices.

Given that most retail traders are trading in the short term, the below example shows the GBPUSD currency pair over the past few weeks.

guide to volatility

GBPUSD ATM Implied volatility comparing to Price Action

You will notice that the implied volatility for the overnight add the money options for GBPUSD shows higher implied volatility. At the same time, you will also see that the price action in the GBPUSD also moves higher confirming the market views on rising implied volatility.

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