Volatility is the key….question: since this is true, couldn’t you just focus on very volatile pairs like GBP/NZD (which just today moved 350 pips) which regularly move hundreds of pips per day on average? If volatility is what we’re after, then focusing on the pairs with the highest ADR seems to be what we would want.
I do believe focusing on volatility is the key to many different problems that a trader might be having. Not all, but many problems can be solved by a trader that masters knowing when the chances increase that a particular market can get volatile or not.
One of the ways to find volatility is to scan the daily charts and weekly charts for the ODVE, MDMM and GM movements. And the intraday charts like hourly or 15 min for the intraday volatility movements. Compare the easy money vs difficult money.
The simplest way is to find the very volatile pairs. HOWEVER, there is one extra step and principle you can apply that will take your trading to the next level.
That is the principle of: You need to focus on volatility that is risk adjusted and for larger hedge funds (liquidity adjusted). Not all volatility is the same. For example if there is a 500 pip spike in the market that lasts 2 minutes, that is not as valuable as a 100 pip move that occurs every day for five days in a row (due to liquidity considerations and time to take profit considerations, etc).
Also, it’s not just about volatility: It is about the current and near future volatility, compared to the historical volatility. For example, if GBP/NZD normally moves 350 pips in a single day, then a 350 pip is no big deal. It is business as usual. However, if GBP/NZD only normally moves 200 pips in a normal ODVE, then a 350 pip move would be above average volatility, which you could take advantage of it because you would normally be using stops assuming a 200 pip normal ODVE, but the market just moved 350 pips in a day, so you have a higher reward risk.
Just because something moves 300 pips in a single day, doesn’t necessarily mean it will move 300 pips or 200 pips the next day in any direction. It may want to chop around for a day or several days or weeks. Whether it wants to move or not would usually depend on the extend of the news/sent/fund/macro forces or on any other market positioning elements.
Also, since the GBP/NZD is at around 2.00, a 1% move for it would be 200 pips, while if the AUD/USD is at 0.90, then a 1% move would be 90 pips for it. Just realize that some of the higher volatility pairs are volatile, because, well, they may trade at a higher price of 1.50 or above, compared to the EUR/USD or AUD/USD, etc.
So in any market, assuming it is a quiet/ranged bound market, you need to compare the volatility that is going to happen, versus the current volatility in the market. Or if the market is already moving and trending and volatile, you have to compare the current vol and near future vol, to the current and prior volatility. It is this way that you can get good reward risk ratio trades, etc.
To give various examples:
Lets say the EUR/USD average move is 100 pips, and you are trying to capture the ODVE move, and decide to position size for 30 pip stop. Well if you go and trade a currency pair that can move 350 pips in a single day, you probably are not going to use a 30 pip stop, because it is too small and you can get stopped out. So if a current pair can move 300 pips, you may want to double or triple your stops compared to a currency pair that can move only 100 pips in a single day. So for the GBP/NZD you may want to use 60 pip or 90 pip stops as an example. Stop losses are based on your interpretation of the information flow, scenarios, how strong and clean you think the news/sent/fund/macro is going to be, etc. But they also have to sometimes be based on the volatility in the market. You can be a great trader and have picked the highs and lows of the day in the past, but if you are trading a volatile instrument, you still can’t use too tight stops.
Or let’s take a stock that moved $20 a share. What does that mean? It’s meaningless. You need more details. If the stock was trading at $1,000 then a $20 move is only 2% move. If it was a $30 stock that rose $20 to go to $50, that could be a monster move. However, you need more details. If that stock’s recent past market action showed that it was making wild $5-15 swings very often, then a $20 move for that stock may not be a big deal, since it was already very volatile and making big swings. So your reward risk might be poor if you had to use wide stops.
On the other hand, if you found a $30 stock that had lower historical volatility, and that moved up $20 to go $50 in a few weeks or months, then that would be a great reward risk ratio trade.
Take another example, if the USD/JPY has recently moved 150 pips in a single day, a newbie might say: Hey, look at that a monster move! However, if the USD/JPY has recently been moving an average of 200-300 pips per day in either direction, then a move of 150 pips, would be below average volatility, and may not represent a good reward risk ratio trading environment. On the other hand, if the average USD/JPY move was 60 pips a day say back in September – October 2012, then if USD/JPY starts moving 100 – 150 pips a day, that could represent a very good reward risk ratio trading environment if you can capture the correct volatility direction.
With this philosophy, you don’t just want to look for volatility. By all means, look for volatility! Look for the ODVE, MDMM, GM and intraday volatility. Look for the easy money vs difficult money. But also take into consideration what the recent historical market volatility has been, to get a more accurate interpretation of what your reward risk ratio can be. How far back to look? That is a good question. I usually take into account the past day or several days, perhaps one week or two weeks. And also, my interpretation of the potential near future news/sent/fund/macro forces to move a market. The market may be quiet historically for days, weeks, months or years, but I may see a scenario or catalyst or something that can make me believe volatility is about to shoot up.
Of course volatility can change at a moment’s notice. It can go from big vol to small vol, or small vol to big vol. An example of big vol to small vol, would be when the EUR/CHF did the 1.20 floor, there was a lot of volatility in the days and weeks prior to that, but once the floor was put in place, volatility shrunk enormously due to the unique changes in the battle of scenarios and news/sent/fund/macro order flow.
So my philosophy would be that you want to in the end, come up with risk adjusted volatility, and the news/sent/fund/macro scenario adjusted volatility. And with that, you take the next leap in your trading journey.