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Posted by John Forman

Yesterday, Tim Mazanec posted on the subject of watching forex volatility. In that post he discussed using the Community Historical Volatility widget to identify situations where a volatility expansion might be setting up. Volatility is something I track constantly to tip me off to potentially very interesting trades developing. I use a couple of common studies to do that. One is Bollinger Bands. The other Average True Range (ATR). The Bands track the volatility of closing price movement, while ATR tracks the size of period ranges (high/low).

In my work with Thomson Reuters IFR Markets I’ve been watching the daily Bollinger Bands get increasingly narrow for NZD/USD. In fact, they haven’t been this narrow in years – the middle of 2008 to be specific, as the chart below shows.

Make particular note of the BWI plot at the bottom of the chart. That is the Band Width Indicator, which takes the difference between the upper and lower Bands and divides it by the middle line (20-period simple average). That gives you the width in a percentage term which can be compared over time. Make note of what happened following the last time the NZD/USD daily Bollingers were this narrow. The Forex market dropped about 500 pips in just about a straight line from the range breakdown, and much more after that initial decline.

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You’ll also see N-ATR plotted on the chart. That is the normalized ATR reading, which means taking the ATR reading and dividing it by the 14-period simple moving average. Like with the BWI, that allows for historical comparisons. Notice that N-ATR was about as low at the start of 2010 as it had when BWI was at its lowest in 2008. It’s ticked up a bit since, but there’s plenty of room for further volatility expansion there.

Now let’s add in the Currensee community data to see where things stand.

Notice that at this writing there is a strong short bias (73%), mostly entered near current levels (0.69791). The longs were entered significantly higher (0.73414), so probably represents traders with a longer-term view. This all comes from the Market Watch widget report when hovering the mouse over the positioning line.

A look at the Historical Volatility widget for NZD/USD shows that the first support level (0.68918) and first resistance level (0.70118) are about 120 pips apart. That’s not quite so narrow as spread between the S3 and R3 levels Tim mentioned, but combined with the other volatility readings noted above, it definitely gives us something to think about.

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The chart below shows the combination of the narrow Bollinger Bands, the relatively low N-ATR reading, and the distance between the Historical Volatility levels (the upper purple looking line is actually both the S1 (blue) and S2 (red) lines, showing how close together they currently are.

All of this tells me that we should be looking for a range break in NZD/USD. My personal feeling is that it will eventually resolve into a move lower based on the bigger picture view, but the volatility readings by themselves won’t tell you direction.

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.

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