Forex Patterns and Probabilities: Trading Strategies for Trending and Range-Bound Markets

CHAPTER 13

The Squeeze Play

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.

THE CYCLE OF VOLATILITY

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.

PERCEPTION MOVES THE 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. ...