I'm sure that most of you guys are exasperated about the current never-ending low volatility environment(see Figure 1) as current market conditions has become increasingly challenging. The Forex Exchange market has been in a very deep sleep for the most part of this year and swing trading opportunities have vanished away and that's one of the reasons why in current low volatility environment the Carry Trading Strategy are preferred more as it makes sense that investors who are chasing yield to rush in and park their money with high yield currencies in seek for return, you can read more about this in my previous article here: Carry Trade Returns

Before going any further we need to define "Volatility", and the way I like to look at it is from two key perspective:
  1. How many times it moves(up and down) in a given period of time --> Frequency.
  2. How faster and bold is the move-->Severity.
In this regard the best definition of volatility I found it to be:"Volatility refers to the frequency and severity with which the market price of an investment fluctuates."

Figure 1. JPMorgan global-currency volatility index.

  • Why is Volatility so Low

Some research I've read so far state that the three-month realized volatility for USD/JPY has not been this low since 1977, and for EUR/USD since 1979. The one reason of this low volatility environment is because of the predictability in Central Bank's monetary policy, and this makes the market more stable, and market reach equilibrium points much faster. Another factor that contribute to this low volatility may be the changes in the FX market structure due to the Dodd-Frank act.

First step for any pro trader is to realize and identify the trading environment that he is trading in and second to have an definable strategy for that environment.

Ultimately at some point volatility will start picking up and move towards mean reversion, as low volatility environment is often followed by a reversion to the mean. And also some may argue that current Central Banks monetary policy divergence may play a factor in favor of the return in volatility, but that remains to be seen how faster it will happen.

Any subsequent change in market conditions will more likely bring the volatility back but we have to wait for a catalyst.

  • How To Trade Current Market Conditions of Low Volatility

Although current level of volatility is at extreme low that's not reason enough to go "long volatility" or "long gamma" as it may be called by some option traders. It takes time to turn the curse of current trend in volatility and the probability still remains in favor of this trend to persist until a bigger catalyst show up. Taking all the above in consideration I'm going to outline a very easy strategy to apply in this environment and also what are the common mistakes we should avoid.

When we're in a low volatility environment trading becomes all about support and resistance and a lot of false breakouts without any follow through so it's kind of obvious the best strategy is to buy bottoms and sell tops and fade any breakout, but again this is easier said than done. The main reason why this is a preferred strategy is because low volatility makes the currency pairs to trade in narrow ranges.

Going forward I'm going to outline a simple strategy to be used when dealing with low volatility.

  • Low Volatility Strategy

Low volatility conditions are characterized by lack of price direction, choppy trading ranges and many big whipsaws that generate a lot of false breakouts.Taking this in consideration by only looking at your chart it should be easier to gauge the market volatility. So, studying just a price chart it can tell you the current market conditions and the volatility conditions.

Figure 2. Measuring volatility with ATR

But we need to quantify this level of low volatility conditions and one way many retail traders are using for measuring the volatility is by using the ATR(Average True Range) indicator (see Figure 2).One way to trade is by using ATR either as a target or by fading the pair once it has reached his ATR level.

Figure 3. EUR/USD Daily chart.Measuring volatility using ATR.

To illustrate some clear example on how to trade this we're going to look on EUR/USD price action over the past few sessions(see Figure 4). Although EUR/USD has been trading in a clear downside trend due to the lack of volatility we have been moving very slow and in tight ranges. From Figure 3 we can see that the Daily ATR year to date is at 69 pips, but for more accuracy we're going to use the ATR over the last few days (14 which is set as default value) which is just 58 pips.

Figure 4. EUR/USD 1h chart

So, lets take session by session (see Figure 4) and see how you could have trade this low volatility conditions by using the ATR:
  • First session start at number 1 and we sold off into 1.3335 support level and we have come close near the daily ATR so we can buy here with small SL for a quick profit of +30pips.
  • Next session we retest the support level but taking in consideration that we're in a downtrend and we barely reached our daily ATR and it could fall further we wait. Next market is spiking up 70 pips exceding the daily ATR and we can fade here this spike after the 1h bar close for a quick +50 pips profit.
  • We retest again the 1.3335 support level but we do nothing again as the daily ATR has not been reached, instead we wait and after we spike up another +60 pips, retesting previous spike up, we fade again this move as we reached the daily ATR and go short for a nice +40pips.
  • We spike higher +50 pips repeating the same pattern from previous days but it's already the end of the day so we stay out on this one.
  • We can go short here as we now from previous sessions all previous spike up where fade away and we're trading in direction of the main trend and use as a target the daily ATR, and although we haven't quite reached the daily ATR taking in consideration the session has ended one could close the position for a nice profit of +45pips.
  • Starting from this session 6 we begin resuming the downtrend and it become much more harder to make a trade based on the ATR unless you're a swing trader and you have your position running for several sessions.
  • The next opportunity only come in session 12 when we reached the daily ATR right into resistance and it's a good play as you're trading again in direction of the main trend.
It's very clear that one must be very selective with his trades in this low volatility environment and only to take setups that appear to be the strongest and in accordance with your trading system.

Mistakes to avoid in Low Volatility environment:
  1. Cashing momentum is a poor strategy;
  2. Trading bigger size to compensate the lack of movements;
  3. Avoid trading breakouts, there are far more false breakouts during this time than usual;
  4. Avoid trend trading strategy unless you're dealing with higher yielding currencies;
  5. Don't set higher expectations, but adjust your strategy to current market environment;

  • How To Prepare For The Return of Higher Volatility

The biggest "threat" to this low volatility environment is a return in risk aversion sentiment that can be triggered by either a serious escalation in the Russia/Ukraine conflict or either a sell of in the US equity market which is less probable. Going long the US Dollar is an obvious choice if you believe volatility will jump as ussualy those currencies that where moving in a nice trend will continue to do so. Also the high yielding currency will experience some retracement as the main reason why they where bidded up was this low volatility conditions, so most likely investors will take profits.

Once the market will start pricing in those higher rates this will translate into higher asset market volatility as well, but we still need a catalyst and the probability still favors lower volatility.
Figure 5. Forex Volatility vs VIX.

  • Conclusions:

Another way to look at the volatility is by comparison with equity market which is still above 2007 levels in comparison with FX volatility (see Figure 5). First thing we must remind ourselves is that once a state of market is in action the probability is that the FX market is likely to stick to tight trading ranges in coming future rather than to have a jump in volatility.Trading only support/resistance levels and fading any move outside the daily ATR is very effective strategy in this environment.

Best Regards,
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