To put it in simple terms, volatility is the amount a market can potentially move over a given time.
Knowing how much a currency pair tends to move can help you set the correct stop loss levels and avoid being prematurely taken out of a trade on random fluctuations of price.
For instance, if you are in a swing trade and you know that EUR/USD has moved around 100 pips a day over the past month, setting your stop to 20 pips will probably get you stopped out too early on a small intraday move against you.
Knowing the average volatility helps you set your stops to give your trade a little breathing room and a chance to be right.
As we explained in a previous lesson, one way to measure volatility is by using Bollinger Bands. You can use Bollinger bands to give you an idea of how volatile the market is right now.
This can be particularly useful if you are doing some range trading. Simply set your stop beyond the bands. If price hits this point, it means volatility is picking up and a breakout could be in play.
Another way to find the average volatility is using the Average True Range (ATR) indicator. This is a common indicator that can be found on most charting platforms, and it’s really easy to use.
All the ATR requires is that you input the “period” or amount of bars, candlesticks, or time it looks back to calculate the average range.
For example, if you are looking at a daily chart, and you input “20″ into the settings, then the ATR indicator will magically calculate the average range for the pair over the past 20 days.
Or if you are looking at an hourly chart and you input 50 into the settings, then the ATR indicator will show you the average movement of the last 50 hours. Pretty sweet, huh?
This process can be applied by itself as a stop or in conjunction with other stop loss techniques.
The point is to give your trade enough breathing room for fluctuations here and there before it heads your way… and hopefully it does.