The average pip movement is simply the average amount of pips by which the price of a Forex currency pair or cross moves in a given amount of time, otherwise known as volatility. It is represented by the Average True Range indicator which shows the average pip movement over whatever length of time it is set to. For example, if the Average True Range indicator is set to 20, and applied to a daily chart, the amount shown by the indicator will represent the average daily pip movement over the past 20 days. There is no reason why this indicator cannot be usefully applied to any other time frame, from the 1 minute to the 1-month charts. This indicator tends to be overlooked by less experienced traders, which is unfortunate, because it can be usefully applied to pick both trade entries and trade exits, as well as to select which currency pairs to trade.
Just as studies of the directional movement of historical prices can indicate the more likely future direction movement by identifying trends or deviations from averages, so can studies of historical volatility indicate the most probable level of future volatility. Academic studies of volatility have shown that the level of volatility tomorrow is likely to be close to the level of volatility today.
Proof of this proposition, that volatility over a current period follows the previous period, can be proven by a back test on some major Forex currency pairs using thousands of samples over almost two decades of historical data:
This shows that slightly more than two-thirds of days have ranged within half or 100% of the volatility of the previous day. In plainer terms, if yesterday’s pip movement was 100 pips, there is probably a 48% chance that today’s pip range will be between 50 and 100 pips. A “clustering” effect exists, even if you only use a single previous period to measure the effect.
How to Use Volatility to Choose Trade Entries
As we have seen that likely future volatility can be inferred from current volatility, using an increase in volatility above the average pip movement as an entry trigger can improve your trading profitability, because it suggests that there is likely to be greater movement in price. For example, let’s say you are looking to trade the GBP/USD currency pairlong on the H4 time frame, and the ATR 30 shows that the average pip movement over 4 hours is 30 pips. You then get a candle moving in the direction that you want to trade in which has a range of 40 pips, and the candle’s high breaks quickly. This tells you that it could be a better than usual time to enter a trade, because the price is showing unusually strong momentum in the direction that you want it to go. Volatility can be used in this way to measure momentum. Of course, the potential disadvantage is that the further the price has already moved before you enter, the higher the chance that the move has already mostly played out. Yet if you wait for average pip movement to be around, say, 25% higher than normal before entering, it will put the odds more firmly in your favor when used on less liquid major currencies such as the British Pound and the Japanese Yen.
Remember also that if you see volatility just beginning to move beyond its average, it is likely to continue to be relatively high, which should also be good news for your trade as it can mean the price will go in your favor relatively strongly and quickly. With the extremely liquid EUR/USD currency pair EUR/USD, interestingly, waiting for volatility to be relatively low works better in picking trade entries.
Another possible technique to apply is waiting for a very strong and fast dip in a trend – a highly volatile movement – to turn back in the direction of the trend, and then entering. This is a high-probability set-up because of two factors: the probability of the trend to continue in its trending direction, and the probability that the volatility will remain high. Taken together, it means that the price is more likely than not to snap back quickly in the direction of the trend. I have published a back test based on this method using the three major Forex pairs, which showed very strongly positive results.
So far, this is an explanation of picking trade entries which focuses upon the price at and just before the time of entry, but there is a wider context to consider. The currency pair that is showing the highest volatility today is likely to be the biggest mover tomorrow, so it might be a wise idea to put your focus there at the start of the next trading day. Also, how about using volatility to decide whether to take what looks like being a good trade entry? Remember that if it is early in the trading day and 80% of the average pip movement for the day has already been made, and you are trading in the direction of the movement, your entry is going to be too late most of the time. For example, if the 20-day Average True Range is 100 pips, and the price was 1.0000 at Midnight and is 1.0090 at 11am, if you enter a long trade then in most cases it won’t advance further enough to make the trade much of a winner. However, on a few occasions it will go much further, but the best trades will usually be the ones which set up before the average range is made.
How to Use Volatility to Choose Trade Exits
The good news is that average pip movement can be used in several ways to optimize your trade exits, as well as your trade entries.
The most common exit method using volatility is used by day traders, who might keep an eye on the Average True Range indicator on a daily chart applied to whatever they are trading. They often look to exit when the pip movement made for the day is approximately equal to the ATR 20. This can be a great method for day traders, especially when the volatility value is close to the location of major support and resistance and maybe a round number as well.
However, there is a common pitfall here. What is usually not understood is that most days, the pip movement does not equal its average pip movement – but on the days when traders can really make a lot of money, the price will exceed that value! This means that if you are aiming for a conservative profit target, you should be watching for something like 80% of the 20-day ATR. This is because on average only 51% of days reach the value of the 20-day ATR. The problem is that you will get a few days where the price just keeps going and going, and by letting these winners run, you can make your trading more profitable. The answer to this dilemma is to watch what the price does as it gets beyond more than 80% of the average daily pip movement. If the price action starts to go flat and you see short-term volatility decreasing, this would suggest that the trade does not have any more profit left in it, at least over the short-term.
Alternatively, if the price just keeps going in your direction like a train, stay in the trade and expect a day of abnormally large pip movement to play out.
Finally, if you are in trade and the price is moving in your favor, and then it starts to move against you with much larger candlestick pip ranges than the advance was showing, it is usually a good signal that it is time to get out of the trade, at least over the short-term, because it is probably going to move even further against you.
Average pip movement is a very useful but often overlooked tool that can be applied easily using the Average True Range Indicator. It can be used to determine:
- Which currency pair(s) or cross(es) are worth trading
- Whether it is probably too late to find a high-probability trade entry
- When a good entry opportunity has come
- When to exit a profitable trade
Want to learn more? Here is a simple guide to learn forex trading.