Volatility
Volatility is a measure of how much the price of a financial instrument (stock, bond or currency) varies over time.
It’s important to understand that volatility does not measure the direction of price changes, but rather how big, frequent and different the changes in value are over a given period of time (the dispersion of price changes). So a currency can be quite volatile (i.e., go up or down a lot every day) without ever going anywhere. Similarly, a currency that rose by 0.5% every day would not be volatile at all, because the changes are the same every day.
Often when people say something is “volatile,” what they really mean is that its price is falling. People rarely call a rising market “volatile,” but they often call a falling market “volatile.” But this is wrong.
Volatility is good for our business. If currencies don’t move, nobody makes money in the FX market, so nobody trades. But as you’ve noticed, sometimes currencies move around a lot and sometimes they don’t.
There are two ways that people talk about volatility in the FX market: historical volatility and implied volatility.
Historical (or realized) vol (people in the FX market say “vol” instead of “volatility”) is the actual volatility of a currency pair over a given period of time. It’s a simple mathematical calculation that everyone agrees on.1
Implied vol is something very different. It comes from the options market. (If you don’t know what an option is, then unfortunately this part is going to be hard to understand!) When market-makers price options, one of the things they have to put into the pricing formula is the volatility of the currency. But since the price of the option is also determined by supply and demand, often it’s different than what you’d get just by plugging the historical vol into the formula. You can take the price of options and back out from it what volatility is implied by the option price. The two aren’t always the same. Sometimes the market assumes volatility will fall, and implied vol is lower than realized vol. Or sometimes people expect a currency to become more volatile and implied is higher than realized.
Notice that right now, implied vol is higher than historical vol. That’s probably because the market is slowing down for Christmas and volatility is falling, but everyone assumes that it will go back to normal once January comes around. In some cases though the difference between the two could show that people are placing big bets on a currency and option prices have gone up as a result. That might alert you to something coming along in the future or to particular interest in a currency pair. For example, KRW implied is much higher than historical, which may be because people expect the currency to appreciate so they’re buying KRW calls. Similarly, the high implied vol for JPY probably means a lot of people are betting on further decline in the yen. Note too that in the case of the South African Rand (ZAR), implied vol is slightly lower than realized vol, because that currency is just so volatile people probably expect the volatility to fall in the future.
You should be aware of which currency pairs are the most volatile. Those are the ones that our clients are likely to get the most action from. You should also be aware when volatility is rising or falling, because it affects how likely our clients are to make money or get stopped out.
1 For those of you with interest in maths, this is calculated as the standard deviation of the instrument’s yearly logarithmic returns, but if you don’t understand that, don’t worry.
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