Thursday, May 23, 2013

Implied volatility and order flow

I'm now beginning to mix some fundamental analysis into my trading methodology. I guess you can say that I'm evolving. :)
I performed a historical volatility analysis on the majors and popular crosses. Each pair does possess a personality that usually reflect their economic and geographical relationship.
As part of my studies into order flow, I've been examining ranging markets and how they behave. If you are going to delve into order flow trading, I think ranging markets would be the easiest to get into. Demand and supply zones are quite easy to mark, as well as your stop loss and profit target.
My historical analysis involved finding the highs and lows of each pair from 2001 onwards, and dividing the high by the low. This would imply the historical volatility of each pair.

The results:

An alternative way of analysing historical volatility would be to simply whip up the monthly charts and plot ADX over a large range. In this case, I chose a period of 120 months (which equals 10 years).

The results:

By comparing the results from the two analysis, we can see that the least volatile pairs are the AUDNZD, AUDCAD, AUDCHF, EURCAD and GBPUSD. After doing some research over the internet, the EURGBP and GBPCHF are routinely mentioned as good pairs to trade ranges. From my analysis, though, they don't seem to be the "best".
If you're going to trade ranges, the AUDNZD would seem to be your best bet. Australia and NZ are both commodity currencies, both are economically developed with similar exports and trading partners, both are culturally and politically similar, and both are in close geographical proximity.
What I found surprising was the relative lack of volatility in the GBPUSD, being a major pair. If you want to range-trade with the least cost, I think the GBPUSD would be a good choice.
What does this have to do with order flow?
My analysis attempted to profile each of the majors and crosses and figure out their "personality", whether they tend to range or trend. The behaviour of each pair is dictated by big money. Us retail traders are much too small to have any influence. However, by getting a snapshot of how the big money traditionally treat each pair, it's almost as if we're taking a peek into their order books. In a range-friendly pair, we know that the big money are more likely to reinforce support and resistance within a narrow range. Trying to trade breakouts would be more dangerous. It's all about finding and accumulating edges.

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