Prepare for another sharp move, here’s why…
The action over the past
week has been quiet but constructive. The market has basically paused
while volume has dried up. After wild daily swings became the norm in October,
the last five days have seen a very tight trading range.
Volatility is like price in that it tends to be
mean reverting. It will stay within a range most of the time, but when it
expands or contracts to an extreme level, you can be sure that it will reverse.
Below is a chart of the S&P 500 showing the 5-day
historical volatility. What you’ll notice is that contractions in volatility
tend to be followed by sharp price moves. You can see that volatility reached
fairly low levels in mid-July and late-September just before the market made
quick moves up. In June and August volatility dried up just before sharp
declines. The opposite is also true. Extremely high volatility readings will
normally to a contraction in price — which is exactly what has happened
recently.
Also notable is just how sharply the volatility
has declined over the past 3 weeks. Volatility may now be overshooting to the
downside. Another sharp price move could be coming soon. Be ready.
I’ve also included a monthly chart. For those who
wonder whether a breakout (or breakdown) at this point could lead to an
explosive move, notice how low the 12-month volatility is and how long it has
already been coiled that way.
Best of luck with your trading,
Rob Hanna
For those who may be looking to expand their
knowledge beyond just market timing, my
Hanna ETF Money Flow System utilizes the VIX in generating trading
signals for spread trades.
Rob Hanna is the principal of a money
management firm located in Massachusetts. He has spent the last several years
developing and refining methods for trading in stocks across multiple time
frames. He selects stocks using both fundamental and technical criteria, and
then trades them using technical analysis techniques.