Like most traders in the U.S., my first experiences involved stock trading. After a rough start, I built a track record that I was able to parlay into a job on Wall Street.

The fact that I didn’t live in New York at the time was a minor detail, and soon I was getting up at around 4:00 AM to begin the trek to work. I would exit my train beneath the World Trade Center, meet up with some co-workers for coffee, and prepare for the all-out war that would begin every day at 9:30 AM.

Eventually I was lured away by another firm, and began working on another trading desk in Manhattan. I moved to New York City, shortening my daily commute from two hours each way to two blocks.

One of the many benefits of living and working in New York City is exposure to people and cultures from around the world. One of the “new” concepts (at least it was new to me) to which I was exposed at this time was the currency market. Once I learned about the advantages of forex trading, I was hooked.

I like to focus on market tendencies that are easy to identify and rooted in logic. One of the more dependable recurring market tendencies is the cycle of volatility -- the concept that periods of high volatility are usually followed by periods of low volatility, and vice versa.

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.

There’s a simple reason 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. 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 a while, a currency pair will reach a point where traders feel that the exchange rate is fairly valued. The bulls and the bears reach an agreement -- at least temporarily -- that the pair is reasonably priced. At this point, the trend pauses and the pair will enter a period of consolidation.

But the pair can’t stay trapped in these doldrums forever. The bulls and bears may have reached a temporary truce, but eventually new information will be introduced into the market, and the perception of value will change as this news is digested.

Moving averages can be used as one indication of volatility. In Figure 1, the 20-period exponential moving average (EMA) bounces wildly during a volatile period. As the pair transitions from high to low volatility, the 20- period EMA begins moving sideways. The flat 20- period EMA is one indication that the trend has paused, at least temporarily, and the price has entered the consolidation phase


Figure 1 -- On the daily chart, GBP/USD consolidates after a volatile period

In order to confirm that a trade is setting up, let’s add two indicators that measure volatility. If these indicators are falling, volatility is falling. Once volatility contracts, the currency pair has settled into a period of consolidation, which could lead to a powerful breakout.

The first of these indicators is average true range (ATR), which measures the average trading range of a pair over a given period of time. In this case, we are measuring the range based on the daily chart, using the default parameter of 14-periods. As we can see in Figure 2, the ATR indicator is falling, meaning that the average daily range is shrinking, and volatility is decreasing.

Bollinger bands also measure volatility. Bollinger bands split open when volatility is high, and converge when volatility falls. Instead of using the bands themselves, we can use the Bollinger band width indicator, which is simply a measure of the space between the Bollinger bands. We can see in Figure 2 that the Bollinger band width indicator has fallen to near its lows, again confirming that we are in a period of consolidation.


Figure 2 ATR and Bollinger Band Width indicate that volatility is falling

We have confirmed that volatility is falling, but this doesn’t give us an indication as to the direction of any potential breakout. This is because volatility has no directional bias; we don’t know the direction of the next move, we only know that a move is imminent. So, we need to prepare for a breakout in either direction.

We can do this by adding trendlines to the chart, and by targeting a break above or below a trendline as an entry point for a directional trade. If the upper trendline breaks, we’ll go long and if the lower trendline breaks, we’ll sell short.

To guard against a false breakout, place a stop below the upper trendline in the case of a long trade, and above the lower trendline if we enter a short trade. Note that the two trendlines form a symmetrical triangle, a common formation during times of low volatility (Figure 3).


Figure 3 Symmetrical Triangles are common in low-volatility markets

When determining our exit points, we want to consider price areas that have previously acted as support or resistance, as well as major Fibonacci retracements and round numbers (see Figure 4).

For example, if the price breaks down past the lower trend line, initiating a short sale, the level of 1.7150 is one choice for a potential exit, because of prior support in that area. A further area of support would be 1.7050, which is the approximate low of the downtrend.


Figure 4 Use of support/resistance, round numbers and Fibonacci to determine exits

What if the price breaks the upper trendline, indicating that we should enter a long trade? For resistance levels, we can draw a Fibonacci retracement of the major downward move from 1.8500 to 1.7050. The 50% retracement of this downtrend, located near 1.7775, makes a compelling exit point.

The 61.8% Fib retracement of the same downtrend could be used as an additional exit. If we reach the first exit point, we can exit part of the position and raise the stop to the breakeven point on the remaining portion of the trade.

The round number 1.8500 is the peak of the prior trend and a previous resistance level, so this could be used as an additional exit point. It would also represent a 100% retracement of the downtrend.

The longer the amount of time spent in the consolidation phase, the stronger the breakout tends to be. Why would this be true? During the time that the price is trading in a narrow range, there are buyers and sellers taking positions. Because the price is not moving very much, these traders have little reason to exit their trades.

But if a breakout does occur, a large number of traders will be caught on the “wrong side” of the market, regardless of the direction of the breakout. As these traders cover their positions, they provide fuel for the breakout, helping to push the price further away from the consolidation area.


Figure 5 Volatility returns with a vengeance

Finally, the GBP/USD pair blasts out of the triangle and races to reach its targets, as volatility returns with a vengeance. This forceful move carried cable all the way to 1.9000, a move of nearly 1500 pips (see Figure 5).

Although this example takes place on the daily chart, similar setups occur in other time frames. The logic behind the setup, and the forex market’s tendency to break out after a period of consolidation, holds true in both long and short time frames.

Traders will see this setup occur over and over again. It works well because the recurring cycle of volatility is made constant by human behavior. Markets may change and traders may come and go, but human nature essentially remains the same.

Ed Ponsi is the President of FXEducator.com and is the former Chief Trading Instructor for Forex Capital Markets. An experienced professional trader and money manager, Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. He is a regular contributor to SFO Magazine, The Pristine View, and FX Street, and is currently writing his first book for Wiley Finance. Ed’s new DVD series, “FXEducator: Forex Trading with Ed Ponsi” is now available at www.fxeducator.com and from select distributors worldwide. For more information, email us at info@fxeducator.com.

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