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.
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.
Markets expand and contract endlessly. Contracting ranges eventually hit neutral triggers where expanding trends are born. Traders can find these pivot points if they know where to look. The analysis begins with a study of wide-range and narrow-range bars for that instrument.
Examine small-bar formations to uncover small shifts in volatility. Narrow-and wide-range bars signal measurable changes in crowd behavior and predict price movement. One classic micropattern is the NR7, or the narrowest range bar of the last seven bars. These tiny bars predict impending volatility breakouts.
Once under way, volatility breakouts can be traded in three ways. First, enter within congestion in the direction of the larger trend and wait for the breakout. Second, buy the price breakout or sell the price breakdown. Third, let the trend get under way and jump into the market on the first pullback.
As an example, I bought
Home Solutions of America
( HOM) on Monday morning just above $5, right after it broke the symmetrical triangle. I doubled the position quickly and then took profits into the test of the September high.
Bar range analysis yields accurate short-term predictions, but not all markets can be examined through range study. For example, low-volume stocks with wide spreads distort volatility signals. It's best to limit analysis to liquid markets with narrow spreads and high average daily ranges.
Many traders use Bollinger Bands without understanding their relationship to volatility analysis. The skilled eye can watch these bands contract and estimate the level of buying or selling pressure required to push them out of the way. These bands work best at the same price levels where constricted ranges trigger NR7 signals.
Once volatility expands and a market thrusts out of congestion, expanding bars will shoot into the Bollinger Band's edge. Here they often form a second congestion pattern. Focus on the interplay between bars and bands at these levels, waiting for the bands open up. This "flowering" predicts price will thrust outward to meet the band within one to four bars.
Alan Farley is a professional trader and author of
The Master Swing Trader
. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback;
to send him an email.
click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.
TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.