In the words of Spanish philosopher George Santayana, “those who cannot remember the past are condemned to repeat it.” While Santayana likely wasn’t thinking of the forex market when he penned that famous statement, the wisdom of his words could certainly apply to the modern trader.
A rear-view mirror look at the price movements of currency pairs has potential benefits for calculating risk management tactics. With this in mind, our fxLabs team created the Forex Historical VaR (Value-at-Risk) Calculator.
VaR is widely applied in the financial world as a means to measure for risk management, financial control, financial reporting and regulatory capital computations. VaR is an estimate of the potential for loss in a portfolio of assets based on their historical performance (assuming normal markets and no trading in the portfolio). A distribution of previous market movements is used to determine the threshold VaR of a chosen confidence level (such as 95 percent or 99 percent).
We decided a VaR Calculator would be useful for some forex traders because it provides a convenient number to represent possible loss. If this number is breeched by the market, it’s worth watching the market closely: is it an outlier, or a sign that the market is changing?
Our Forex Historical VaR Calculator can be used to estimate reasonable losses or gains, or to serve as another window into the market. For example, based on your trading strategy and risk tolerance, you could use the VaR calculator to determine a reasonable stop-loss level or a possible maximum value to set take-profit.
Like any financial market, the forex market is not predictable, and past performance can never be solely relied upon to predict future direction. Liquidity, regulatory, sovereign, and other types of economic events can affect forex prices drastically in a short period of time, and you need to be prepared. You should never rely on the VaR number as your only data point; always be on the lookout for other factors as you trade.
Using the Forex Historical VaR Calculator
To get the information you need, experiment with the OANDA VaR Calculator settings. Try different confidence levels (choose from 50 percent, 75 percent, 95 percent, or 99 percent) and instruments (the currency or metal pair). Adjust the chart granularity (the length of time per candle) and trade duration (number of candles) to see the varying results.
The Forex Historical VaR Calculator updates the VaR number based on the settings you choose:
In example No. 1, the maximum candle granularity is chosen, so the VaR reflects a long time period of 300 days. If you were trading EUR/USD and planning on holding it for a while, this VaR of 182 pips might be a reasonable stop-loss level, provided it’s backed up by other considerations. On the other hand, a take-profit level greater than 182 pips is unlikely to trigger anytime soon, and may not be realistic, especially if you plan to hold the position for a short period of time.
Viewing Price Movement Distribution
The VaR tool calculates the percentage occurrences for every price movement (in pips) for the 300 most recent candles during active trading. These movements can be in either direction, low-high or high-low.
The tool plots the distribution of these movements to determine the price movement at the confidence level you specified. You can choose to show a graph to see this distribution:
Example No. 2 shows how to use the VaR tool to focus on the volatility of a currency pair over a short time period (in this case, over the past 25 hours of trading). The graph is useful because it gives a visual clue to the volatility of the market. Note the 35-pip outlier value on the chart. This is by far the biggest observed movement -- much greater than the average movement or the VaR. In fact, a series of large price movements sitting higher up on the chart is skewing the average (12 pip movement) away from the median (10 pip movement).
If you were trading EUR/USD and planning on holding it for only a few hours, 23 pips might be a stop-loss (or take-profit) level to consider, although the large price movements at the top of the graph hint at some wild price swings that would warrant further investigation and caution.
The Forex Historical VaR Calculator is one of many tools OANDA provides to help you analyze the forex market, and we encourage you to use it for your trading decisions and strategy.
Please share your experiences using the OANDA VaR Calculator in the comments box below.