13.2 Three Rules of Volatility

Additional Reading About Three Rules of Volatility

Three Rules of Volatility - Text Version

In the last lesson, we said that measuring volatility is a way to make an accurate forecast of the most likely next price movement. In this lesson, we will look at three mathematical rules of volatility which you can use to make these forecasts and improve the profitability of your trading.

The first rule is that volatility tomorrow tends to be close to the amount of volatility today. This is known as “volatility clustering”. For example, if the EUR/USD has been moving by about 50 pips every day for a few days, it will probably move by about 50 pips tomorrow. If tomorrow, the price moves by much more than 50 pips, say by 100 pips, then the day after that, the price is more likely to move by an amount closer to 100 pips than 50 pips.

We can prove this first rule by looking at some historical Forex price data. Over a recent 15-year period, we looked at the autocorrelation of today’s volatility to yesterday’s volatility on the Euro-Dollar and Pound-Dollar currency pairs. Both currency pairs showed positive autocorrelations over hundreds of samples.

The second rule is that when volatility is relatively low for a long period of time, the longer the time period, the more explosive the eventual increase in volatility. This means that when a currency pair’s price is moving little over a long time, such as several days or weeks, it becomes more likely to make a strong directional breakout.

We can prove this second rule by comparing how Forex currency pairs move following breakouts. When the price has been contained within a narrow range, say less than 3%, for the last 20 days and breaks out, the breakout is on average stronger and travels further than if the range has been more than 3%.

The third rule of volatility is a logical consequence of the first two rules we already explained. This third rule says that the best time to enter trades is when volatility has begun to increase from a relatively low amount. Applying this filter to practically any trading strategy tends to increase profitability.

We can prove this third rule by the fact when a Forex price breakout is triggered by a larger than average candlestick, it tends to be more profitable than when it is triggered by a smaller than average candlestick.

In this lesson, we have shown how measuring volatility can help you find better trades and improve your profitability. In the next lesson, we are going to look at the tools you can use to measure volatility.