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A NUGGET OF TRADING WISDOM TO SHARE WITH YOU:
Fig: SP500 Daily that is close to a collapse in volatility of price bars, (in rectangle) leading to strong down move
What is market volatility?
Volatility is a measure of dispersion around the mean or average return of a security. One way to measure volatility is by using the standard deviation which tells you how tightly the price of a stock is grouped around the mean or moving average (MA). When the prices are bunched together, the standard deviation is small. When the price is spread apart, you have a relatively large standard deviation.
Another way to measure volatility is to take the average range for each period, from the low price value to the high price value. This range is then expressed as a percentage of the beginning of the period. Larger movements in price creating a higher price range result in higher volatility. Lower price ranges result in lower volatility.
The stock market is a volatile place to invest money. The daily, quarterly and annual moves can be dramatic, but it is this VOLATILITY that also generates market returns.
Market Performance and Volatility
There is a strong relationship between volatility and market performance. Volatility tends to decline as the stock market rises and increase as the stock market falls. When volatility increases, risk increases and returns decrease. Risk is represented by the dispersion of returns around the mean. The greater the dispersion of returns around the mean, the larger the drop in the compound return.
Market behaviour is predictable to a degree, but no one can predict what a specific market will do at a precise time. The market business is not one of predictions but one of probabilities. As one TV ad rightly declared: If you want a fortune-teller, the place to go is to the circus.
When we have enough experience, we will know that price history repeats itself. From price history, one can extrapolate predictable patterns of price behaviour because they are fractals as I mentioned in an earlier post about the Golden Mean and fractals occurring in markets as well.
Having said this, there is a pattern which I recall that my mentor Ray Barros has once pointed out to me to watch out for. It is the pattern known as a ‘collapse in volatility’. This collapse in market price volatility occurs when trading ranges narrow substantially, so that the price chart bars of whatever time frames suddenly get smaller. These price bars should be at least three in a row and do not need to get progressively smaller in each bar.
However, we should not confuse a collapse in volatility with a trading range or congestion or sideways pattern. A trading range has some support or resistance levels, which are also longer in duration than a collapse in volatility. The bars are also not so narrow.
What happens next is a probable trigger of a significantly bigger price move – which could be up or down. Sometimes, the use of additional technical indicators may help us see which direction the market is likely to go.
Suffice for me to say, when you observe such a collapse in volatility in price movements in a chart of any time frame, be forewarned of a bigger price move to come, which could either go north or south.
ANA aka IDKIT