How Volatility Can Sabotage Your Technical Analysis

Technical analysis is a blend of an art and a science. It cannot be one without the other.

While its inner-workings are somewhat of a mystery, one thing we do know is that it relies on market perception. A pattern or level that stands out as obvious to one experienced trader is likely obvious to many other experienced traders. Through this idea of perceived value, technical analysis just “works”.

But what happens when a level or pattern is only obvious to a handful of traders using the same broker?

Heavy volatility, which is common in the Forex market, can cause this to happen. So instead of seeing things from the same (or similar) perspective as the rest of the market, you see a fragmented view of it.

This fragmentation can be disastrous for the technical trader who relies on price action to determine areas of value. The good news is that there is a solution to this problem; a very easy one, in fact.

By the end of this lesson, you will not only understand how volatility can misdirect your technical analysis, you will know how to overcome it.

Typically when I show someone what I’m about to show you, the immediate response is to blame their broker for not offering the “correct” price. But the disparity in pricing between the brokers you are about to see isn’t really about right versus wrong.

Rather than focusing on the broker, it’s much more advantageous for you to focus on what you plan to do in the event this happens to you. Because once you are aware that heavy volatility can cause different Forex brokers to display widely different pricing for the same currency pair at the same time, you will be better able to account for it when you do your technical analysis.

That said, I have seen cases where the price action that is offered through a broker’s feed is absolutely abysmal. I’m not going to throw anyone under the bus here, but as long as you stick to one of the larger, more regulated brokers in the industry, you should be just fine.

For example purposes, we will be using one of the more popular tools when it comes to technical analysis – the Fibonacci retracement tool. Of course, anything that affects the use of this tool can just as easily affect other areas of your analysis, so be sure not to discount the following lesson in the event you don’t use this particular tool.

I was recently asked a question regarding a multi-year high on GBPNZD. The question pertained to using the Fibonacci tool to help determine where the pair might run into selling pressure on the way back up from a recent low.

It went like this – which of the two highs in the chart below should be used as the starting point to identify the key Fibonacci levels?

This was a valid question given the volatile spike in price (first high) that could throw off the Fibonacci sequence.

Under normal circumstances, you always want to use the swing high or low. In the case of the chart above, that starting point would be the high of the largest candle.

However, with the answer I gave, it wouldn’t matter which high this trader used because they would both technically be “incorrect”.

Here’s why…

The three charts in the image above are from three different brokers (Pepperstone, FXCM and Forex.com). Notice that the actual multi-year high for GBPNZD varies widely depending on the broker.

To put things in perspective, the range from Pepperstone (highest high) to Forex.com (lowest high) is a massive 564 pips. This presents a huge problem – and a potentially costly one at that – for the trader who is trying to determine the “true” swing high in order to use the Fibonacci tool.

Just imagine if three traders, each using one of the three brokers above, attempted to draw out the Fibonacci sequence on a GBPNZD chart. It would end up looking like a plate of spaghetti.

On second thought, why imagine when we can draw it out?

Not very helpful, is it?

If this is what traders from those three brokers see, just imagine how the entire retail market is seeing these levels. I would bet that just about every single price from the swing high to the swing low would be accounted for if you did this exercise using every broker in existence.

This is obviously not ideal when your primary duty as a Forex trader is find and trade from the most obvious levels in the market.

All of that said, this does not mean that the Fibonacci tool is useless. I use it quite often and have found great success with it, especially when using it to identify potential major tops and bottoms.

What all of that does mean, is that the tool is only accurate when used in the right market conditions.

What are the “right” conditions, you ask?

Put simply, conditions where high levels of volatility are not an issue.

When used during periods of increased volatility, such as the one in the GBPNZD chart above, the tool is rendered quite useless. In fact under extremely volatile conditions, the Fibonacci tool can be downright dangerous to use as it can lead to false positives when drawing your key levels.

Lastly, the misdirection that volatility can cause doesn’t stop with something like the Fibonacci retracement tool. Any other tool or method of identifying key levels off of a volatile spike in price can be misleading, causing you to mark a level that may not be universally obvious.

There are two things you can do when faced with volatile conditions like the one we just discussed.

The first is the most obvious, which is to do nothing. That may sound like I’m being sarcastic, but I assure you that doing nothing is an extremely viable option as a trader. In fact, it’s the recommended option if you are ever unsure about what to do.

Remember, your number one job as a trader is to protect your capital, making money comes second. Also remember that you have dozens of currency pairs to choose from. So no matter how good a trade setup may look, it helps to know that it probably isn’t the only one out there.

The next option as it pertains to using the Fibonacci tool is something that I always do, regardless of the level of volatility in the market. That is to only give credit to a Fibonacci level if it lines up with a predetermined level on your chart.

This is something I have talked about before as a way to gauge whether or not these levels have any real significance, or if they are simply false positives that can throw you off.

For many, the idea of an increase in volatility means a greater opportunity to capitalize on price movement. While this is true to some degree, a heavy increase in volatility can also misdirect your technical analysis, making it difficult to identify truly favorable trade setups.

Therefore it’s important to always take the current level of volatility into account when performing your analysis. While your broker may do its very best to offer reliable and accurate pricing, odds are that it will vary greatly from other retail brokers during periods of intense price swings.

Knowing this will allow you to discount the reliability of any false positives, putting you one step ahead of the retail crowd.

What do you think? What is your favorite method of dealing with high volatility in the Forex market?

Leave your feedback using the comments section below.