Ever since the FX Probe back in 2013, regulators have been delighted to wrap red tape around one of the last “wild west” markets still standing: Foreign Exchange.  Since then, regulators have essentially banned directional trading within investment banks, and the function of dealing desks has purely shifted to “facilitation”.

However, there is a fine line between the risk that dealers took onto their books, in order to create a market (potentially standing in the way of a very strong unilateral move) and an outright speculative bet. Unfortunately, in order to discourage these practices altogether, salaries have been cut and senior staff (i.e. experienced dealers with 20+ years in the industry) have had to relocate into other lines of business.

The limits of the new, highly regulated FX market, are quickly showing up. One evident example is the Sterling Flash Crash in October 2016.

Even the Bank of International Settlements found this event particularly worrisome (the pound plunged 9% in a matter of minutes during early trading hours in Asia). The organization concluded that “less experienced” traders handicapped by a limited knowledge of which algorithms to use at that moment “amplified” the rout.

Since 2013, there has been an accelerated shift to automation, substituting “expensive, old-school dealers” with a generation of less market-savy quantitative traders whose decisions are driven by mathematical models. The effect, which we have been experiencing, is a lack of liquidity and lack of a 2-way market at those times when it’s most needed.

What This Means for the Retail Trader

So what does this means for the Retail Trader? The current conundrum is that daily volatility has been dropping progressively, whereas intra-day volatility has risen dramatically.  The B.I.S., in the reports mentioned above, is actually finding out that rookie traders, lower liquidity and algorithmic market making are primary factors driving this change in market dynamics.

So what we need to do, as retail traders, are two things:

  • incorporate a “volatility check” into our plans;
  • make sure our stop losses incorporate a “buffer” and are not exactly 1 pip above/below a swing high/low.

This way at least we remain cogniscent of the current daily volatility and the overall trend in volatility. There isn’t one best way to do this. One way track volatility is to track Bollinger Band compression/expansion, which is incorporated into Sam’s Market Type analysis. In order to enhance your skills,  you might want to insert the values into an Excel sheet and compare them, in order to really understand what you’re looking at when you see contraction or expansion.

Perhaps run some correlation tests just to see which currencies track each other the closest – hence saving time and avoding running too many tests. You might also want to try to diversify them a bit by incorporating TRY and ZAR so you can get a sense of whether its general risk off or just trading.

Now for some pointers: USD/CHF probably reflects the DXY more than any of the other majors so run CHF or the DXY, not both. EUR will cover most European based currencies (as far as general direction goes) with the exception of Cable which has always marched to its own drum  and of course USD/JPY as it responds to both interest rate differentials and equity movements more directly than any other currency. USD/CAD also marches to its own drum but is impacted strongly by the DXY, US rate differentials and crude oil. However, it does present opportunities – particularly on the crosses – despite being the least trend following of all the majors.

My personal favorite, for measuring volatility contraction/expansion is the Average True Range, which is potentially more useful from a momentum perspective (is it widening steadily, contracting steadily or just choppy?). This gives you a sense of whether you are in a trending market or a trading market.

 Volatility and Trading Tactics

By keeping track of volatility conditions, you are stacking the odds more firmly in your corner. With rising (directional) volatility, it becomes possible to be more active in the market. When volatility is rising, pyramiding becomes possible, more aggressive trade management becomes possible, multiple entries become possible. And all this simply because the market is moving strongly. But this doesn’t happen often. In 2016 there were only 2 occasions when we had such occurrances: after the Brexit vote, and after the US Elections.

When volatility is contracting, we must be more cautious. We need to stay flat more often, and select our entries wisely. Once seated, we also need to refrain from taking multiple entries in the same direction because trend risk (how far we have pushed in line with the trend) becomes more of an issue.

Basically, keeping tabs on volatility allows you to stay in touch with general market conditions and not treat each & every trading day (or week) in the same way.

Over To You

While algorithmic market making has not changed the nature of the trading game substantially, it has created a conundrum: there is more intraday volatility and less daily volatility. Liquidity has become an issue and flash crashes are something we will see more often.

But these changes do not significantly impact the retail side of things. As retail traders we do not have liquidity issues. As retail traders we remain flexible and can decide when to participate and when to stay flat. We can monitor volatility conditions and choose our spots wisely.

What about you? Have you noticed any significant differences in your trading since 2013? Do you monitor volatility regularly? What have you noticed?

About the Author

Justin Paolini is a Forex trader and member of the team at  www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.