FX markets are vulnerable to a range of factors that cause price fluctuations, and many investors modify their strategies to take advantage while also ensuring FX currency protection.
Currency volatility is measured by computing the standard deviation or variance of currency price movements over a given period. A higher volatility means more significant price swings, suitable for trading. But investors should be careful not to become overconfident. Investors should also look at the true average range and the spread as a percentage of the spot price.
The higher the degree of currency volatility, the higher the level of market risk, and vice versa. Volatility and risk are usually used as interchangeable terms. Highly volatile currency pairs tend to have higher levels of market risk.
Some investors prefer highly volatile currency pairs because of their potential for high rewards. Still, these rewards bring an increased level of risk, so investors should reduce position sizes when trading volatile currency pairs to retain FX currency protection.
You can increase your FX currency protection by taking note of the following volatile currency pairs:
These other currency partners aren’t as volatile while remaining more liquid:
On the other hand, these emerging currencies mark some of the highest volatility ratings and low liquidities despite being new players in the trading field:
How come new currency pairs tend to have higher risk and lower liquidities? One measure of that volatility is how emerging market currency pairs bulge or deflate over time. For example, take a look at this. USD/ZAR (US Dollar/South Africa Rand) bulges nearly 25 percent over a month. In addition, there are several other examples of emerging market currency pairs bulging or deflating this much over a short period throughout history.
Knowing what you know now about currency volatility, this will help you make the most of your investment:
You can find countries with stable currencies by looking at historically low debt-to-GDP levels. High debt-to-GDP ratios can lead to inflation, which negatively impacts investors’ confidence in the local currency, driving it lower.
When a country's currency is more robust (relative to the foreign bond’s currency), the value of the bond and its future interest payments can be significantly reduced.
Given this significant risk of foreign bonds, investors might want to steer clear of them. However, foreign stocks can offer a different opportunity since stocks can grow faster and offer more upside.
The currency pairs with the least changes in value tend to be the major currency pairs that are liquid and often involve larger, more developed economies. Exchange rates in these economies are more likely to be stable in value. This nourishes more trading volume and yields better price stability among the most liquid currency pairs.
The most liquid currency pairs with the least price fluctuation usually involve the Euro, Swiss Franc, and British Pound.
Observing this graph, the average true range of USD/CHF ranges between 45 and 65 times the average true range, a low average true range compared with other currency pairs. The true average range (ATR) is a technical indicator used to measure the volatility of a currency pair.
Turning to the US Dollar and Swiss Franc on the same link in the previous paragraph, we see that their historically positive relationship will lead to less volatility. Both currencies are viewed as safe-haven currencies, so their positive correlation signifies a lower investment risk and a lesser need for FX currency protection.
The US Dollar and Swiss Franc tend to strengthen when investors are risk-averse, but they may not deviate much from each other. This helps keep the volatility of this currency pair to a minimum.
Highly-volatile currencies tend to change price more often than those with low volatility. Because they move more frequently, high-volatility currency pairs are riskier to trade than low-volatility currency pairs, hence the need for FX currency protection at the onset.
The greater degree of movement in high-volatility currency pairs makes it difficult for traders to hold the position for an extended period. Due to this greater movement, position sizing is crucial when trading high-volatility currency pairs.
Traders usually measure these risks to determine the correct position size. Some of these measurement methods include:
Every country has its currency, with its exchange rates for foreign currencies. When one country’s currency is more robust than another country’s currency, it can buy more of the other country’s currency.
When one country’s currency is weaker than another country’s currency, it can buy less of the other country’s currency. It could be challenging for an investor to keep up with exchange rate movements, but this metric changes how much investment in international markets will return.
Suppose you want to acquire shares from a (fictitious) French food company called Food from France. The shares are trading at €50, which means that with the current exchange rate, €50 is equal to £45.02 (50 x 0.9004). If you bought 100 shares, your initial outlay would be £4502 (100 x £4502).
But say, in this instance, you don’t execute your order for two days. Although the share price of Food from France has remained the same, a Brexit announcement caused the pound to depreciate against the euro, bringing down the price at which you’d get a buy order to £46.25 per share. At a new exchange rate of 0.9250, you would be paying £46.25 for the shares, for £4625. Calculating the original price against the current amount due to foreign exchange, you paid £123.
Hedging forex is a strategy to protect one's position in a currency pair by taking a second position in the opposite direction. This method is usually short-term protection when a trader is concerned about news or an event triggering volatility in currency markets.
There are two approaches commonly used when talking about hedging forex pairs in this way:
Let's look at both more closely:
Although holding two opposing positions in the same currency pair may sound like madness, it is often used by traders who have long-term positions in a currency pair and want to protect them against short-term movements. Rather than liquidate their entire position, which could be a considerable amount, they will enter another trade to offset any losses they see coming up and protect their long-term gains.
A speculator can create an imperfect hedge in the spot market by buying put options to reduce the downside risk from price falls and buying call options to reduce the risk from price rises.
For example, imagine a forex trader has purchased a Euro/Dollar futures contract at 1.2575. The trader believes the currency pair will continue to rise over the next few weeks but is also concerned that it may fall in the weeks after a potential downturn in the economy.
One way to hedge risk would be to purchase a put option contract with a strike price of 1.2550, allowing the trader to sell the contract back to close out the position for $1.2550 if EUR/USD drops below that point so that she does not have to take a loss on the trade.
If the option is exercised and the EUR/USD rate moves lower, the trader will be better off because the put limits the risk to 25 pips (the difference between the strike price and the market price at the time of purchase), plus the premium paid for the contract, no matter how much the pair drops. The trade may not begin with a significant profit like a call, but it will defend against a loss.
For example, imagine a forex trader is short GBP/USD at 1.4225 but is concerned it may be on the wrong side of moving higher if the upcoming parliamentary vote is bullish. The trader could hedge some of that risk by purchasing a call option contract with a strike price of 1.4275 and an expiration date after the scheduled vote.
If the vote comes and goes, and the currency pair doesn’t move higher, the trader can keep the short GBP/USD trade and make profits as it falls lower still. The cost of protecting the short-term trade equals the premium paid for the call options option, which is lost if the GBP/USD stays above its strike price throughout and expires before the vote.
If after the votes are counted, and GBP/USD starts moving higher, being short GBP/USD suddenly isn’t nearly as risky because thanks to the call option contract, losses are limited to 50 pips plus any option premiums paid for protection (0.0050 + 100 = $1), known as intrinsic value.
Despite the GBP/USD climbing to 1.4375, the maximum risk is not more than 50 pips, plus the premium. This is because the trader can exercise the call to buy the currency pair at the strike price and then cover the short GBP/USD position, despite what the market price for the pair is at the time.
Because this trade entails a high probability that much less margin is required, a trader can set up a number of these trades to ride out minor market fluctuations while keeping her capital reasonably safe.
Less volatility doesn’t always mean improved earnings from trading. As we’ve learned today, traders need to evaluate their markets, make wise choices carefully, and hedge their bets (fully or partially) to protect themselves from unnecessary losses.
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