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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 VIXFor 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 Unfortunately, this classic indicator is badly outdated and does a poor job of capturing rapid movement triggered by modern program-trading algorithms.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 RangesMarkets 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 - Get Report) 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.
Bollinger BandsI looked at multi-time-frame Bollinger Band analysis
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.