Tracking and Trading Volatility Cycles

This column was originally published on RealMoney on Dec. 14 at 12 p.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Traders and investors make more money in volatile markets than in quiet ones. But few of us really understand the underlying cycles that generate lively and dead price action. It's worth our time to understand the difference between these two states of market activity, because long-term profitability depends on it.

All stocks and indices cycle between bursts of intense movement and periods of relative calm. This unfolds in all time frames, regardless of liquidity or fundamentals.

The sum total of this activity shows up on charts as trends or trading ranges. It also characterizes the testing process when advancing or falling price establishes new boundaries.

Logically, the most profitable trades come right at the end of a quiet period and the start of an active period. Of course, we have to be positioned on the right side of the market to take advantage of the major cycle shift.

This is a major challenge, because price expansion in the form of wide-range bars is much easier to predict than actual price direction, as shown on the Dade Behring (DADE Quote) chart below.

Narrow range patterns sitting near support or resistance signal impending shifts from low- to high-volatility states. They tell us something is about to happen, and we need to pay close attention. But they don't predict the direction of the impending price movement. We need to rely on other technical tools, such as moving averages, to accomplish that task.

On the flip side, contracting price bars give us the opportunity to plan pre-emptive trading strategies to capitalize on impending movement, regardless of which direction it finally takes. These aggressive tactics include bi-directional orders that enter the market in whichever direction the price expansion finally unfolds.

Keep in mind that volatility cycles are restricted to the time frame you're watching. For example, the 60-minute chart may be quite volatile, while the daily chart for the same instrument shows a dead market. Deal with this conflict by looking for the price/time interface where the two cycles intersect. That's where the trending movement will begin.

Volatility dynamics have little value if you can't find a way to trade them. So let's look at three common ways to measure expanding and contracting markets.

The VIX

For most traders, volatility study begins and ends with the market volatility index, or VIX. This broad measure attempts to gather up all equity movement and spit out relative levels of market instability. Unfortunately, this classic indicator is badly outdated and does a poor job of capturing rapid movement triggered by modern program-trading algorithms.

Market gurus make consistently bad calls on market direction when looking at long-term VIX trends. That's your clue to avoid the indicator for all trading decisions, because it's a great way to lose money. As we discovered after the bear market ended in 2002, the VIX can fall to dramatically low numbers and just sit there for months, years or longer.

Bar Ranges

Markets expand and contract endlessly. Contracting ranges eventually hit neutral triggers where expanding trends are born. You can find these quiet interfaces when you know where to look. Start your egg hunt with a close examination of wide-range and narrow-range price bars for that particular instrument.

Grupo Televisa (TV Quote) has rallied up to an all-time high below $28 and dropped into a tight sideways pattern. Note how the last price bar has a smaller high-to-low range than the six bars preceding it in the weeklong congestion. This confluence of price and time is issuing a volatility-based trading signal called the NR7.

The NR7, or narrowest-range bar of the last seven bars, does a great job of predicting impending volatility breakouts. But these bars need to be positioned correctly within rangebound markets to increase their predictability. A NR7 sitting at the centerpoint of a tight triangle, like it is on the Grupo Televisa chart, offers a great example of proper placement.

The most reliable volatility breakouts start with a gradual decrease in the length of range-bound bars. Watch these small patterns as they move into support or resistance and just sit there. Positions can be taken when the NR7 shows up, with a tight stop-loss sitting outside the two-, three- or four-day range.

Bar-range analysis yields profitable short-term predictions. But not all markets can be examined through range study. For example, low-volume stocks with wide bid-ask spreads distort volatility signals. So limit your analysis to liquid markets with narrow spreads and high average movement.

Bollinger Bands

I looked at multi-time-frame Bollinger Band analysis in a recent column. This handy tool offers an alternative to simple bar-range study. The trick is to watch constricted bands and estimate the buying or selling pressure needed to push them out of the way. The process is very effective in strong trends where price bars hit upper or lower bands repeatedly. Check out the action in TriZetto Group (TZIX Quote).

When a stock or index breaks out, expanding bars often shoot into a band's edge and then drop into a tight congestion pattern. When you see that happen, turn your attention to these levels and expect price bars to move sideways until the bands open up to allow further directional movement.

The combination of bands and micro-patterns creates a powerful interface to track and trade all types of volatility cycles. For example, a NR7 sitting in a perfect position vis-à-vis the top or bottom Bollinger Band increases the likelihood that the volatility expansion will unfold, exactly as expected.