Knock on effect and Market Pull effect are classic examples of fundamental analysis at work. Unless you know how to do fundamental analysis properly, this strategy can lead to catastrophic losses. However, if you have a firm grasp on fundamental analysis, you can use this strategy to your advantage and make huge profits without even looking at technical analysis and because we do not have any technical analysis involved, we don’t have to deal with any charts and graphs and indicators. I see that smile on your face! Let’s get started with the concepts.
Market Pull Effect
When any event or news directly impacts the value of an asset, it is called Market Pull effect. An example will be better. Let us assume that in two days US trade figures will be announced and that you have deduced from market activities and events from the past that the figures will not be good. This will eventually lead to devaluation of US dollars and it will become weak against other currencies. So, while trading in currency pair, you will USD/(any other currency) and use a Put option because USD will fall against that other currency. For instance, you select USD/JPY. Your bet will be on Put option. If however, you select the reverse, i.e. JPY/USD, your bet will be Call option because Japanese Yen will be gaining value again USD because USD will lose value because of bad trade results.
Similarly, if you know about a good news from British government, the value of Sterling Pound will increase compared to other currencies. So, if you trade GBP/USD, your bet will be Call option because GBP will be gaining due to the good news. On the contrary, if you select USD/GBP, your bet will be Put option because GBP will be gaining but on the other hand, USD will not gain but will rather fall.
The problem comes in when you have good news for both countries whose currencies you want to trade. For instance, good news from both US and British governments will mean that the value of both GBP and USD will rise. Whether you go for GBP/USD or USD/GBP, it will be tough call because both will have strong movements and hence, more volatile market. The best thing to do here is to pair each currency with some other currency. For example, you may pair GBP with JPY and go for Call with GBP/JPY or Put for JPY/GBP. On the other hand, you can pair USD with AUD and go for USD/AUD with Call or AUD/USD with Put.
Knock On Effect
Market Pull Effect was about direct impact of some news or event on a particular asset. Knock on is slightly different. Here the news or the event that affects the asset does not even look remotely related to asset you want to trade. “An example will be good” – is that what you are thinking? Okay, let us simplify things for you.
Let us assume that tomorrow morning you pick up a good and reputed newspaper and see a news which says, ‘Strong Hurricane Hits Gulf of Mexico’. What can you analyze from here? Yes, oil production can be halted for a while. This will drive up the oil price (Market Pull Effect) and you go for Call option if you directly trade in oil. But what about the companies that process the oil extracted at Gulf of Mexico? They will experience a spike in their stock prices because their profits will increase and you will go for Call option if you trade in the stocks of these oil processing companies. This is Knock On Effect. There is another one here! Those that depend (they don’t process but rather use oil as a raw material for their products’ production process) on the oil produced at Gulf of Mexico for their business will have their costs increased, which in turn will drive down their profits and hence, their stock values will decline. Here, for these dependent companies, you will go for Put option.
So, it is all about how you analyze and interpret any event or news and see which companies are going to make profits and which ones are going to lose! You go wrong in your interpretation and you are in danger! Thus, it is all about identifying the different connections and then trade accordingly.