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The Traders Wheel
10/17/99 by Alan Farley

Volatility

Measuring volatility opens the door to successful price prediction. But first take the time to understand exactly what it means. The financial media overuses this important concept to describe any market movement that they don’t understand. And baby-faced analysts fall back on it constantly to explain their bad predictions. So how do traders use this valuable tool without getting caught in useless labels?

TASC (Technical Analysis of Stocks and Commodities) describes volatility as "a measure of a stock's tendency to move up and down in price, based on its daily price history over the latest 12 months". While their definition fixes upon a single time frame, it illustrates the relativity aspect of market movement. Over time, markets take on unique characteristics that can be measured through price swings. One well-known example is price rate of change or the average number of points that a stock moves over a specified period of time.

Volatility builds on this quantitative analysis of price by removing direction from the equation. It stretches pure increments of price change so that their relative travel can be measured. The greater the distance over time, the more volatile the market. But pure volatility has little value for traders if they can’t base price prediction upon it. Fortunately volatility has a characteristic that contributes to profitable trading. It tends to move in cyclical patterns.

Markets expand and contract endlessly. As prices ebb and flow, volatility moves cyclically between active and inactive states. Relatively new (outside the options world at least) techniques have developed over the last 15 to 20 years for analysis of this phenomenon. Many tools now focus on the relationship between price swings over time and their current movement. Others predict the future through the pattern of wide and narrow range price bars.

As ranges contract, so does volatility. Like a coiled snake, markets approach neutral triggers from which sharp price movements erupt. Properly tuned indicators can identify these trend-range interfaces and offer a powerful supplement to classic pattern analysis. Use charting software with range analysis functions to extract this information directly from chart patterns.

Technicians can also capture these pivot points using pattern recognition. The impact of narrow and wide range bars has been known in the futures community for years. Application of this important analysis to equities is just reaching maturity, as very short term trading becomes part of the stock market landscape. Read works by Raschke, Crabel, and Taylor to polish your trade execution skills with this important concept.

Complex indicators capture cyclical changes in volatility, regardless of relative price movement. Raschke/Connors Historical Volatility, a recent addition to the technical arsenal, predicts impending price movement but not necessarily direction. Skilled traders apply a dual strategy and either go long or short depending on outcome.

 

 
Alan Farley is a full-time trader and author residing in Denver, CO. He publishes The Hard Right Edge premier web site for trader education, technical analysis and trader resources featuring both Morning Trader and Traders Workshop. The site provides traders with comprehensive resources including original tactics and strategies on multi-trend technical analysis and short-term trading .

  Alan also authors on-line training technical analysis in association with independent sites. His most recent publications include the Mastering The Trade on-line workshop, Momentum: Riding The Tiger, and Time of Day. In addition to writing, he is an outstanding speaker and lecturer on short term trading strategies.

 He has been featured in Barrons, Smart Money magazine, Tech Week, MoneyCentral and TheStreet.com.

 

 

 

 
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Last modified: April 02, 2001

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