With daily trading volume in excess of $6 trillion, the forex (FX) market is the largest and most liquid financial market in the world. Forex, or foreign exchange, trading is the buying and selling of currencies and is notorious for its extreme volatility.
The term “volatility” is used to describe the degree to which the value of a currency pair changes over a specific time frame. You might expect high volatility or low volatility from this currency combination.
Whatever the case may be, it is essential for forex traders and investors to have a firm grasp on the factors that contribute to volatility in the market, as this knowledge will have a significant bearing on their ability to make informed trading and risk management decisions.
In this article, we will look into six key factors that drive volatility in the forex market.
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The 6 factors that drive volatility in Forex
These are the factors that drive volatility in Forex:
1. Geopolitical events
The volatility of the foreign exchange market can be significantly affected by geopolitical events such as elections, trade disputes, wars, and diplomatic tensions.
When investors avoid a country due to political unpredictability or uncertainty, the currency of that country declines in value. When hostilities are resolved or good things happen on the geopolitical front, this can increase the value of a currency.
For instance, as news and updates regarding the Brexit discussions were made public, the value of the British pound fluctuated widely. Rapid price changes are commonplace after geopolitical events because traders are quick to buy and sell currencies in response.
2. Economic data and news releases
The release of economic data and news can be a major source of volatility in the foreign exchange market. GDP growth, employment numbers, inflation rates, the consumer price index (CPI), retail sales, and manufacturing indices are just some of the economic data that governments and central banks regularly provide.
Currency prices can fluctuate significantly in response to these announcements since traders and investors use them to gauge the strength of an economy. If a country shows robust economic development and low unemployment, for instance, foreign investors are more likely to buy its currency in hopes of a profit.
Conversely, a currency’s value can decrease in response to bad economic news. Sharp price changes and increasing volatility are the result of traders regularly monitoring economic calendars and reacting swiftly to news releases.
3. Interest rates and central bank policies
Changes in interest rates and the actions of central banks are major contributors to swings in the foreign exchange market. To curb inflation and spur economic expansion, central banks like the Federal Reserve in the United States and the European Central Bank in the Eurozone utilize interest rates.
When a country’s central bank boosts interest rates, it draws in investors from other countries who are looking to make a profit. By contrast, the opposite is true: the central bank can weaken the currency by lowering interest rates or implementing unconventional monetary policies like quantitative easing.
Large price fluctuations might occur after traders digest central bank meetings and announcements for hints about future interest rate changes.
4. Market sentiment and speculation
The forex market is highly sensitive to changes in investor sentiment and the results of speculative trades. Expectations about how the currency market will evolve in the future can affect the choices made by traders. If investors are confident that one currency will appreciate in value, they will likely buy it.
On the other hand, if traders become pessimistic about the currency owing to economic or geopolitical difficulties, the value of the currency could fall precipitously as a result of widespread selling. Amplification of market sentiment via social media, financial news, and online forums can heighten volatility as traders react to the prevailing mood.
5. Breaching of technical levels
Many foreign exchange traders rely heavily on technical analysis, which involves keeping a close eye on important price levels such as support and resistance levels, trendlines, retracement, and structural breaks. When prices approach or break through these points, it can signal a heightened level of trading activity and volatility.
If the price of a currency pair, for instance, breaks over a key resistance level, traders may use that as a sign that a bullish trend is beginning. There may be a spike in market volatility if traders start buying the currency pair in expectation of future price increases.
Equally, a negative trend may be in progress if the price of a currency pair drops below a key support level. If they think the price of the currency pair will continue to fall, traders may start selling it. There may be a sharp drop in price as a result of this increase in supply, which would enhance market volatility.
6. Liquidity and trading hours
Forex market volatility can be greatly influenced by market liquidity and trading hours. The foreign exchange market is open around the clock, five days a week, with the most active trading occurring during daylight hours in London, New York City, Tokyo, and Sydney. Overlapping trading sessions can enhance volatility because of the greater amount of trades that occur.
For instance, the Japanese yen and Australian dollar may witness larger price swings during the Asian session, while the euro and US dollar may see greater volatility during the London-New York overlap. Due to fewer market participants, volatility in prices is also possible during low liquidity periods like holidays and weekends.
Navigating the forex market successfully
In order to trade and manage risk effectively in the foreign exchange market, it is crucial to have a firm grasp of the variables that contribute to volatility.
Currencies shift in response to news of economic activity, changes in interest rates, global events, market sentiment, and availability of funds. Foreign exchange (FX) traders and investors need to keep up with market news and adjust their approaches accordingly to succeed in this ever-changing market.