Newcomers to forex trading are frequently inundated with disclaimers on every forex website that trading currencies is high risk and that special training is a requirement to swim in these shark infested waters. For those that heed these warnings, they soon learn in their basic course of study that adhering to prudent risk management techniques and managing the size and number of open positions are paramount to success. As an accomplished trader, however, you also need to be aware of risk levels at all times.
How does one assess and measure market risk levels? To begin with, risk equates to uncertainty, and when markets are uncertain, they are volatile. For the highly technical forex trader, implied volatilities for various currencies can be discerned from the futures market and can give guidance to expected trading bandwidths. One can assess the actual volatilities for individual pairs by keeping tabs on their respective Average True Range ATR indicators.
For the general market, however, traders typically follow the behavior of the VIX volatility index. Here is a chart for the past eighteen months:. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over the next day period. To convert to a monthly range, you would divide by 3. Critics claim that the VIX is merely a measure provided from current index options, using complex calculations derived from the Black-Scholes equation.
It is not an accurate forecast of the future thirty days out. Much of this kind of debate is academic in nature, but, as a forex trader, you are only looking for a general feel of how other traders are thinking.
Will volatility translate into chaos, which means more opportunity in the forex market? As the chart depicts, volatility fell through the floor this past summer, as if everyone sold in May and stayed away until August and September, a summer siesta of sorts. It even appears that a quarter of the trading community got nervous mid-vacation, returned to their screens, and modified their open positions in August. The herd returned after Labor Day, assessed market conditions, and then went crazy in October, trading with reckless abandon.
The winner was the U. Dollar, as sanity returned to the global marketplace. The VIX has now returned to the lower boundary of its normal trading range. The tenor of the futures market is one of consolidation, almost pausing to contemplate the next major moves.
The fear of another recession, however, hangs over Europe, and their major trading partners are holding their collective breaths. Concerns that more volatility is ahead and that a liquidity crunch, similar to , is imminent are beginning to surface. That strikes me as a dangerous combination and unlikely to be resolved smoothly. Experts have often believed that risk can be totally hedged, but the financial collapse of five years back destroyed that myth. Statistical pricing models depend on normalcy within two standard deviations, but outside of these norms, the so-called fat-tail anomalies can wreak havoc on any theory and decimate liquidity.
Smith sees many disturbing similarities in our current situation that harken back to the last financial crisis. Investors have globally chased return in our low-interest-rate environment, concentrating capital in emerging market debt denominated in Dollars. His sober warning is: When they do, we'll rediscover why traders consider the FX market the pound gorilla that stomps on the stock and bond markets without even noticing the squishing sound.
Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite.
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