How to Read and Play Volatility Signals

The markets are getting more volatile these days, or at least that's what the talking heads are telling us.

Volatility readings can help traders understand market cycles and improve price prediction. I use three technical tools to gauge current volatility and predict its expansion or contraction. These measurements often trigger immediate opportunities, but they can also yield data that don't require an instant response.

Markets alternate continuously between bursts of intense activity and periods of relative calm. We watch this pulse as prices step up or down to a new level, test a new trading range and then break toward another level. As one phase nears its end, the chart often prints a small-scale pattern that signals an impending rally or selloff.

The volatility cycle offers an important piece of trading wisdom: Price movement is easier to predict over time than price direction. This may sound vague, but in essence, volatility signals tell us to pay close attention because something important is about to happen.

Volatility removes direction from chart analysis. It stretches price change over time so relative travel is laid out end to end. Simply stated, the greater the relative distance over time, the more volatile that market is.

But these dynamics have little value if we can't find a way to trade them. Fortunately, volatility has another characteristic that makes it an excellent trading tool: It tends to move in cyclical patterns.

Many folks think the CBOE Volatility Index (VIX) is the only way to understand this characteristic of price action. Indeed, the indicator helps traders read broad market sentiment and its impact on the ticker. As I wrote last week, it's also a valuable tool for predicting turning points.

But the VIX is almost useless for individual stock analysis. In essence, it just predicts how jumpy and nervous traders will get if the market turns against them. Using this information, we can project their participation at key levels, but we can't know how this will translate into price direction.

Volatility describes a market's tendency to move up and down over time, on the basis of its recent history. This definition highlights the relativity aspect of trends. Markets develop characteristics that can be measured through price swings. But these readings must first be adjusted for periodicity, or the size of the swing being examined.

For example, Boeing (BA Quote) had low volatility during its rally off its September lows but high volatility within the swings of the last two weeks. This pattern also predicts that longer-scale volatility will expand soon, yielding a rally or selloff from current levels.

I'm looking for a rally, because volatility constriction at breakout levels suggests a market that wants to head much higher.