Exploit Volatility in Your Trading

Do these market laments sound familiar?

"The markets are too volatile."

"There's not enough volatility; there's no follow through."

Indeed, markets cycle through periods of low volatility and periods of higher volatility, characteristics options traders regularly exploit. But short-term, swing and intermediate-term traders can incorporate volatility into their trading plans, too, by remembering two characteristics of volatility.

Sheldon Natenberg, in his Option Volatility & Pricing, makes two generalizations about the characteristics of volatility that we can put to use: volatility is mean-reverting and exhibits serial correlation. In short, these two characteristics collectively mean that periods of high volatility (extreme price moves) will be followed by periods of low volatility (smaller price moves), and vice versa, as volatility returns to an average or mean volatility.

This collective characteristic is easily observable on charts. Markets expand and then consolidate, rally and then pause, in an endless cycle. The collective characteristic often predicts larger-than-normal moves. If a wide-ranging market has been trading within a narrow range for several days, the traits of volatility imply that a larger-than-normal move -- in either direction -- is imminent as volatility returns to normal. Hence, you will often see big moves out of triangle, pennant and flag patterns.

Let's go to some current examples to illustrate the principle in action.

Moving Out of Low Volatility

Based on closing prices, July unleaded gasoline (HUN2: NYMEX) has had wide-ranging price swings over a three-month period as depicted by points one, two and three in the following chart. But over the past seven sessions, closing prices have been nearly flat, setting up a much greater likelihood that the range will expand as volatility reverts to its mean.

Again, the volatility imbalance does not predict market direction, only the increased chance for a big move. However, notice that the trend in unleaded gasoline is down, the crest of momentum is down, and the market has been making lower highs. This suggests that the expansion out of the low volatility situation will be down.

The situation in August heating oil (HOQ2: NYMEX) is similar, with three months of wide price swings followed by a week of narrow closes. Again, downside momentum and lower lows suggest the mean reversion and serial correlation characteristics of volatility will kick in with an outsized move to the downside.

Finally, July cotton (CTN2: NYBOT) is also setting up to revert to its mean by transiting out of a low volatility situation with a big move. The next chart shows that relatively wider-ranging changes in closing prices over the past three months have been followed by tight closes over the past seven sessions. Again, the characteristics of volatility do not predict direction, only that a larger-than-normal move is in store. However, the trend has been decidedly up in cotton. Cotton would also trigger a pullback from a multi-month high should it trade above the high of the low in bar in the pullback above 38.95.