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The theory behind the efficacy of the coiling pattern is that once a stock's price has become "coiled," that precise condition will not last for very long and will soon be followed by a decent expansion in volatility. That volatility expansion as reflected in the price action and change of the underlying stock is invariably at least 10% or more away from the price point where the stock's coiling action came to its conclusion.
Coiling action does not predict future price direction! Please make note of that fact and reread that previous sentence if you must, in order to permanently understand what coiling action does not attempt to signal or portray. Coiling action is predicated on the volatility of a stock and is not in any way a harbinger of future price direction.
The coiling of a stock's price occurs when three moving averages conjoin. I have predetermined through too many years of vigorous trial and error that these three moving averages are the most significant ones. The price point where they meet is where you will find the end of the contraction of the current volatility cycle for any underlying stock.
That end of the coiling action can thus be seen on any stock's one-year chart (do not use any chart other than a one-year chart if you are attempting to identify coiling action!). Those three moving averages form a price "junction" of sorts, where, if you were to take a pen or a cursor, you can actually cover all three moving averages with one dot. That point is the price point where the coiling action has reached its completion. It is at that time and price where the volatility should have finished its decline and it's where a new round of higher volatility should soon commence. The three moving averages I use to identify my coiling pattern are the 10-day (or 10-period), the 46-day and the 230-day. I do not encourage you to vary from these moving averages, as my work highly suggests that my averages are the optimal periods and days to use to obtain the best results when data-mining the coiling pattern.
These three moving averages represent traders and investors who are positioned, long as well as short, in the stock. Those individuals and fund managers represent any stock's short-term (10-day), intermediate-term (46-day) and longer-term (230-day) positioned players in the stock at that time and price.
The stock market, being dynamic, must eventually move away from any price level over time. Our economic world is ever-dynamic, and any stock's price is constantly either in flux or will soon be, as the price of any stock is a representation of both its current and future value. The coiling pattern is totally dependent upon this theory of the eventuality of price change for any stock. History provides evidence for this key assumption of the dynamic of price change.
My coiling-pattern analysis began when I was floor trading during the 1980s. Whenever one of my primary stocks (if not all of them as well as the entire stock market!) had its volatility get crushed, I swore that I would someday formulate a computer pattern that would be designed to give me a "heads up" to that eventuality. Think of this quest as trying to find a stock's volatility "canary in the mine"! Being in a situation where you are long hundreds of options that are decaying at a much faster rate than you ever expected is akin to owning a fruit or produce store where nobody comes in to buy what is fast decaying on your store shelves! It is not much fun to experience, and it is highly stressful and not conducive to anyone's economic and emotional well-being.
As I always played options from the long side of gamma, I was always at risk relative to any ensuing decline in volatility. I still twitch when I hear the "sound" of the "vols" being crushed! To be long literally hundreds of calls and puts, and to then be forced see them decay on a daily basis, is just awful. That decline in your capital is captured by professional trader's clearing firm's daily position "sheets" (the P&L and income statement for the pro trader). Those recordings of your growing losses are not a good thing to have to endure. To be able to predict the vols getting crushed is extremely important for dodging or surviving any volatility crushing.
What I did not foresee, but quickly envisioned, was that since my coiling pattern signaled the end of the volatility down cycle, it was also signaling the beginning of a new one. Thus, this is the point where you will be able to use this residue of my coiling pattern, as it is a major if not the uber-important technical pattern for buying volatility. To that end, I will address just how to do so in next week's Big Idea.
Skip is a former registered options trader and member of the Philadelphia Stock Exchange. He was an equity options analyst and broker with Paine Webber and a proprietary trader for Van Der Moolen. He served in the USMC, as well as played minor league baseball with the N.Y. Yankees organization. He is an independent stock and options market consultant.