FXP Stock Trading

The Squeeze Play

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As we noted earlier, most good trading strategies begin with a market tendency; traders notice that the market tends to behave in a certain way, and then they create a strategy that seeks to capitalize on this tendency. Let's look at a strategy that is designed to take advantage of volatility in the forex market.

Volatility tends to run in cycles. In other words, periods of high volatility tend to be followed by periods of low volatility. There is a simple explanation for this; when a market is trending, as the forex market often does, the participants have a definite opinion as to the direction of the trade.

This cycle can be observed in almost any trading market, but it's most closely identified with options trading. Options traders write put and call contracts during periods of high volatility, to collect the "premium"—the cost of the contract. The premiums attached to these contracts tend to be fatter when markets are volatile.

The option writer assumes volatility will return to normal levels in the future, allowing him to buy back the contracts at a reduced premium. In the world of options, this concept is referred to as selling volatility. This cycle of volatility can also be observed in the forex market.

When a currency pair begins to trend, traders are showing a strong preference for one currency over another. During strong trends, the market is volatile because the price is on the move. The perception of value has changed, and the price must move to reflect this change of opinion.

After the trend has continued for a while, the currency pair will reach a point where the participants feel that the exchange rate is fairly valued. There will come a point when the bulls and the bears reach an agreement—at least temporarily—that a currency pair is reasonably priced.

At this point, the trend pauses and the pair enters a period of consolidation. The price settles into a narrow range, as there is no real reason for the exchange rate to break out one way or the other. The period of consolidation may be brief or lengthy.

Eventually, this period of consolidation must end. The bulls and bears may have reached a temporary truce, but eventually new information will be introduced into the market, and the perception of the value of the currency pair will change as this news is digested.

Economic indicators are often the catalyst for this change of opinion. Unexpected news events can cause the exchange rate to break out of its narrow consolidation, and run until the price reaches a new area where the bulls and bears are once again able to reach a temporary truce.