Historically, when the market is concerned about inflationary pressures, money is moved away from most investing instruments and toward gold. This pattern of behavior was apparent during the hyper-inflationary times of the 1970s when gold prices went from $35 per ounce to nearly $700 per ounce, nearly a 2,000% increase in one decade. The dollar index during this same time period saw a decline of approximately 11%, not nearly as dramatic as the climb in gold prices. The dollar index used during this time period was discontinued in 1998. The move to gold reflected the concern and impact of inflation on all markets, not solely the dollar. In periods of deflation, commodities, including gold, receive the brunt of the sell-off where the value or purchasing power of the dollar relative to goods and services is growing. Deflation was seen between mid 1980 and 1983 where the dollar index grew by nearly 40% and gold saw a similar drop of just over 40%.

If investors move money toward gold during times of inflation and toward the dollar and away from gold during times of deflation, why would both gold and the U.S. dollar be strengthening at the same time and what is the opportunity it represents?

The answer to the first of these questions is fear. Fear or uncertainty is what will drive money to perceived safety. As is evident from the VIX, there is a higher level of volatility and uncertainty in the equities markets. As investment money has looked for a safe haven, money has been moved toward gold, fixed income, and cash positions. Both cash positions and fixed income increase the demand for the U.S. dollar and in turn, strengthen the dollar. Looking at the continuous futures contract for gold and the CME continuous dollar index, it is evident both have strengthened over the past three months. The gold and dollar bullish moves have been simultaneous with the fear and uncertainty which have plagued the investment markets.

Gold Continuous Contract (GC1700) Rising Over the Past 3 Months

U.S. Dollar Continuous Contract (USX1700) Rising Over the Past 3 Months

The opportunity lies in both trend-trading as well as watching for one of these two, normally opposing instruments to reverse direction. As uncertainty continues with no direct signs of inflation from Consumer Price Index (CPI) or Producer Price Index (PPI), trading gold and the dollar in the direction of the bullish trends is supported by both price and fundamental pressures. Trading gold positions can be accomplished by trading gold futures contracts, the gold ETF (GLD) and even by trading gold mining stocks. The U.S. dollar can be traded by trading dollar futures or by trading the spot markets.

If the probability of immediate inflation concerns in the U.S. remains low, trading the dollar against a country that has a higher probability of inflation increases the odds of success. Standard & Poor's downgraded Spain's credit rating from AAA to A this week. As can be imagined, it is not a common occurrence for an entire country's credit rating to be downgraded. The last time this occurred was during the "Asian Flu Crisis" in the 90s. This recent credit rating downgrade will impact the ability of Spain to sell off debt and will, consequently, directly impact the strength of the Euro. In addition to the demand of the Euro potentially decreasing, the Euro Zone CPI is higher than the U.S. CPI. Comparing the recent trends and last month's CPI reports, inflation will likely hit the Euro before the dollar. As can be seen from the EUR/USD chart, the pair has favored the dollar as price action has dropped nearly 3,000 pips since July of 2008 and has fallen nearly 1,500 from the three-month highs. The recent support area near 1.25 may come into play and swing traders may find the a bearish move an appealing target. From a fundamental and longer-term view, rising inflation in the Euro Zone could drive the pair further, closer to parity over the next year. A position trade such as this could take multiple months, while volatile price changes in the shorter term may be seen.

The EUR/USD Pair in a Down-trend, favoring the U.S. Dollar

A bullish Dollar, bearish Euro trade can be exacted on numerous trade instruments including the currencyshares ETF (FXE), CME Euro FX Futures, currency options provided by ISE and PHLX, and the Forex spot market (EUR/USD). The key to longer term, fundamental trades is to watch for shifts that would disrupt the fundamentals. Fortunately, there are weekly and monthly reports reflecting inflation data. As mentioned before, if the CPI and PPI indicate inflation (positive percentage numbers) in Europe while less so in the United States, the bearish trend could continue for some time. If, however, the U.S. shows inflationary pressures, reconsidering the long-term view would be appropriate.

thinkorswim, Inc. does not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.

Neither Investools nor its educational subsidiaries nor any of their respective officers, personnel, representatives, agents or independent contractors are, in such capacities, licensed financial advisers, registered investment advisers or registered broker-dealers. Neither Investools nor such educational subsidiaries provide investment or financial advice or make investment recommendations, nor are they in the business of transacting trades, nor do they direct client commodity accounts or give commodity trading advice tailored to any particular client's situation. Nothing contained in this communication constitutes a solicitation, recommendation, promotion, endorsement or offer by Investools, or others described above, of any particular security, transaction or investment.

Stock direction, time decay and implied volatility are the three core components that make an option price change. Only one of the three can be truly counted on, and that's decay. But the amount of time for sale and the speed of the decay process can be dramatically affected by changes in volatility. With this in mind, trading with time decay on your side can be much less of a Maalox moment if one has an indication of existing market volatility levels.
Sometimes I like to sell volatility when it's probably excessive and buy when it's likely in a quiet period. This takes a contrarian's mindset. I would expect what is happening now to change. I zig when others zag, shake when others bake, buy when everyone else is selling or even pick the Cardinals to go to the Superbowl. But knowing when volatility is high or low is a challenge. The VIX is a great indicator for analyzing this, but we can use some other volatility indicators like Bollinger bands to shed some light on the subject.
The Bollinger bands expand when price volatility increases and contract when volatility decreases. The contrarian thought is to add positions that sell volatility, like Iron Condors, when the bands are relatively wide while using positions that buy volatility, like calendars, when the bands are narrow.

One could add a confirmation filter to improve the value of the concept as well. For example, if the bands are wide open and price goes outside of a band, this would indicate extreme levels of volatility that carry odds of contraction, while a price touch of a band in narrow circumstances improves the likelihood of a volatility expansion period.
I don't use these bands to replace my usage of the VIX and wouldn't expect anyone else to do that either. But if you'd like to explore market price volatility along with implied volatility, the bands might help you hold things together.

thinkorswim, Inc. does not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.

Neither Investools nor its educational subsidiaries nor any of their respective officers, personnel, representatives, agents or independent contractors are, in such capacities, licensed financial advisers, registered investment advisers or registered broker-dealers. Neither Investools nor such educational subsidiaries provide investment or financial advice or make investment recommendations, nor are they in the business of transacting trades, nor do they direct client commodity accounts or give commodity trading advice tailored to any particular client's situation. Nothing contained in this communication constitutes a solicitation, recommendation, promotion, endorsement or offer by Investools, or others described above, of any particular security, transaction or investment.

It is difficult, if not foolish, to call the end of a strong trend, especially as strong of a trend the Japanese yen has experienced over the past eight months. In less than six months, the yen has been the strongest currency when compared to major world currencies, strengthening from 23% against the U.S. dollar to more than 60% against the New Zealand dollar. With such positive yen movement, planning for a reversal needs to be done in a precise, analytical way. The analytics I'm referring to are fundamental and technical reasoning for a trend reversal.

Beginning with the fundamentals, knowing why the yen has strengthened can help determine when its strengthening is over. During the past few years, volatility changes have driven the yen. It gains strength when volatility rises and weakens when volatility drops. It also has a history of being part of the "carry trade" in which banks and institutions sell it at a very low rate (between 0.0% and 0.5% over the past five years) and buy higher interest currencies to capitalize on the differential of interest rates in a leveraged market. Many analysts accredit the carry trade for the volatility correlation with the yen. As volatility rises, institutions are less likely to take higher risk or leveraged trades. The carry trade, though a profitable methodology, is considered higher risk due to the leverage. As volatility has risen over the past year, short yen positions have been covered, driving demand for the yen up. Basing sentiment for the yen on volatility alone, using the VIX as our volatility indicator, volatility has fallen from a peak of more than 80 in October to near 40 this week, creating a bearish sentiment.

In addition to lower volatility, the Japanese economy has struggled significantly. Japanese gross domestic product (GDP) has fallen four quarters in a row and economic growth has constricted to an annualized rate of -12.7%, the worst GDP rate since 1974. Institutional tracking, derived from the Commitment of Traders Report (COT), indicates similar bearish sentiment as yen positions are currently net short on 60,000 contracts. Price has diverged significantly from institutional selling.

The most dramatically oversold currency in the past year has been the New Zealand dollar. The New Zealand dollar is highly correlated to commodities and is currently the highest interest-yielding currency of the major world currencies. A long trade on the NZD/JPY is bullish on commodities, favors the carry trade, and is bearish on the yen and struggling Japanese economy.

Considering price action and technical analysis of the NZD/JPY pair, the commodity channel index has created a bullish divergence at a multi-year low and support (see Figure 1). Additional confirmation can be obtained if price action breaks through the trend line. A break above the trend line may also be considered a trend reversal.

Figure 1 -- Potential Bullish Divergence between Price and Commodity Channel Index

Although Figure 1 is a chart of the NZD/JPY spot currency pair, a similar trade can be created by trading CME futures. This can be accomplished by buying or going long on the New Zealand dollar future (NEM9 for the June Future) and selling or going short on the Yen Futures (JYM9 for the June Future). Because of the similarity and correlation between the Australian and New Zealand dollars, a similar scenario can be seen on the AUD/JPY pair, which can then be traded with one long CME aussie dollar/ Japanese yen Future (AJM9 for the June Future). This analysis is for a potential trend reversal and not for risk management or timing. Be sure to use good risk management in all trade opportunities.

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The security used in this example is used for illustrative purposes only. Investools is not recommending that you buy or sell this security. Past performance shown in examples may not be indicative of future performance.

Trading spot currency contracts can involve high risk and the significant loss of any funds invested. Spot currency contracts are highly leveraged. This means that significant losses can be created quickly and unexpectedly.

Options trading is generally more complex than stock trading and may not be suitable for some investors. Granting options and some other options strategies can result in the loss of more than the original amount invested. Before trading options a person should review the document Characteristics and Risks of Standardized Options, available from your broker or any exchange on which options are traded.