Newbies setting forth to learn Forex trading may have heard mention in the Forex trading courses of the term “volatility ratio”. Here’s a quick look at what it is and how you can use it in your Forex trading.
In straightforward terms, it’s a technical indicator that seasoned traders use to identify price ranges and breakouts. In the stock market, it’s used to determine a stock’s true trading range on the basis of its true price range, and to locate situations where the price moves out of this true range. Generally speaking, stock traders tend to extract more value from it. But provided it’s not used as a sign of Divine Truth, it can easily be used to analyse currency pairs in Forex trading.
The volatility ratio was derived from another technical indicator called the “Average True Range” or ATR: this is a moving average tracking true ranges, usually over 14 days. These are:
- current high and current low
- the absolute value (i.e. actual rather than relative value) of the current high minus the previous close
- the absolute value of the current low minus the previous close
The volatility ratio divides an asset’s true range by the ATR over a specified time interval. When it reaches or exceeds 0.5 in value, it signals a potential breakout.
In the Forex market, where currency contracts are traded 24 hours 5 days a week, there’s far less likelihood of breakouts occurring cleanly and suddenly. For that reason, it’s best to think of the volatility ratio as a confirmation tool to help guard against preconceived beliefs about currency pairs. You can use it to track volume indicators, helping you clarify your entry and exit points. For example, take the case of a currency pair undergoing a surge in volume. If is also has a volatility ratio of 0.5, that would be a great moment for entry.