Saturday, May 23, 2015

Price and volatility contraction - the coiling of a spring

According to an article on CNBC this week, the Dow is on course to form its tightest price range (in percentage terms) in the first half of any year since its inception back in 1896.

Price has currently remained within a range of just over 6% so far within 2015. Sure, there have been some sharp moves on a intra-day basis, or over the course of a day or two, but these have all been contained within those basic price boundaries.

Readers who have followed me for a while will now that, when looking for trading setups, I look for volatility contraction as part of my trade selection criteria. The theory is that, after a period where price consolidates and volatility dries up, there is an expansion in volatility as price starts to move out of its own range. I often liken this to the coiling of a spring, which is then released.

I talked here about the short signal given last year about the EUR/USD which coincided with its own lowest volatility reading since the Euro was created in 1999 - and we know what happened there.

Now, while the volatility indicator on my own chart of the Dow is not showing a similar level of contraction compared to that on the EUR/USD last summer, this price and volatility contraction it is worthy of note.

Traders in the UK will know that the FTSE has been sitting in a tight rage for around two years now, and any attempted breakout of price into a new range has been quickly rejected, or sluggish at best. Currently price is trying to move up and stay above the previous all-time high (set back in December 1999), but cannot gain any traction.

So at the moment, these indices are trapped.

All we know is that price (in any stock, index or instrument) moves between trending and non-trending phases, but we never know when they will switch from one state to another, or the duration and magnitude of each phase. All we can do is observe what is happening, and when price moves from a period of price and volatility contraction within a non-trending phase, to a position where a new price move may be starting, then that is cue to try and jump on board that potential new trend.

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