In This Issue:

Utilizing Volatility for Short Term Trading

By Scott Hoffman, Senior Broker, Daniels Trading

Volatility is a commonly used word when talking about the markets, especially these days! We are experiencing unprecedented market swings in virtually all market sectors this year. While volatility can be intimidating, it can also be used as an indicator and trigger for trade generation.

Volatility tends to be cyclical. Markets tend to move from periods of low volatility to high and back to low. As periods of low volatility often lead to volatile periods, recognizing a low volatility situation means that one has an edge in anticipating when an expansion in volatility is forthcoming.

Exploiting volatility swings is aided by understanding the concept of positive and negative feedback systems. These terms are often used in the sciences, but are a good framework for analyzing market behavior. A positive feedback system is one that starts out in an unstable equilibrium. In the case of a market, it is a contraction in volatility that occurs when neither buyers nor sellers are able or willing to commit to a market, causing a contraction in volatility and smaller trading range.

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Positive feedback occurs in such a system when something occurs to disturb the market’s equilibrium, causing market participants to adjust their perception of perceived value. As perceptions change, the market moves away from its equilibrium, with traders deciding to buy at higher prices, or sell at lower prices. As the market moves away from the equilibrium point, positive feedback kicks in as more traders decide to either liquidate losing positions or initiate trades in the direction of the nascent trend. Increasing distance from the initial breakout point often amplifies the new trend.

Eventually this new trend moves far enough that buyers decide a market is “too expensive” to continue buying, or “too cheap” to continue selling. This sets up a negative feedback system with a stable equilibrium, where movement away from an equilibrium point tends to be dampened. I like to use the example of a home heating and cooling thermostat for a negative feedback system. When it gets cold, the thermostat signals the furnace to begin to produce heat to warm the house up to the desired temperature (stable equilibrium point). When the equilibrium temperature is reached, the thermostat tells the furnace to stop producing heat.

I developed my Trade or Fade Advisory to codify volatility markers, so I could anticipate changes in volatility, and then to use this information for trading decisions. I start by comparing today’s trading range to the previous day. If the range is 70 percent or less of the previous day, I flag the market for a potential breakout directional move (positive feedback) or “Trade” day. I also compare the day’s range to the previous four-the narrowest range of the previous four days signals a Trade day. Finally, a doji bar (a day where the high and low are within 20 percent of each other) signals a Trade day.

Once we know to anticipate a breakout, directional move for a trading session, we need to find entry and exit triggers. Breakout systems often use the previous day high and low for entry points, or compute entry points some distance from the previous day’s close or the current session’s open. I developed the Trade or Fade support and resistance levels to use for my short term trading. These price levels are proprietary calculations that are based off recent market action, and centered on the session open.

To see how I approach breakout trading, below is a daily chart of the December NASDAQ. We’ll look at the activity for December 1st. December 1st is the bar in the middle of the ellipse, with the callout arrow pointing to it. By sight you can see the indications for a breakout-an extreme range contraction and a doji day.

Click here to Enlarge Chart

Below is the Trade or Fade advisory for the December NASDAQ futures for December 1st. This is the report that is sent out shortly after the market open (in this case about 6 PM the night before). As the report shows, December 1st was a Trade Day-the range was 89% of the previous day, it was also an inside day, and the narrowest range of the previous four.

The first support and resistance levels are the breakout entry points, that is, look to buy a move above first resistance (R-1), or sell a break below first support (S-1). The initial stop loss can be just on the other side of the pivot. Profit targets are the next two distant resistance or support points.

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Below is a 5 minute chart for the NASDAQ for December 1st. The short entry was hit shortly after the 8:30 open. Rather than risk to the open, stops above the pre-open high around 1165 kept the risk lower. Within 100 minutes of entry the market traded down to 1118, and proceeded to trade sideways for four hours before breaking down to the S-2 profit objective.

Next we’ll look at March T Bonds, again for December 1st. The daily chart is below. The daily chart has two days of range contraction and two doji bars. This meant the market was primed for a move on the 1st (the bar to the right of the callout arrow).

Click here to Enlarge Image

The Trade or Fade report for December 1st is below. The previous day was 74% of the day before, but as the previous day saw a big range contraction, there still was a valid Trade signal. The report also shows that the preceding day was the narrowest of the previous four (the NR4 box).

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Here’s how the day played out. Bonds opened about unchanged, and began to rally early in the session. First resistance at R-1 was hit about 4:30 AM, and the market tailed lower for about 3 hours, as R-1 served as resistance early in the session. By my rules for this system, I placed stop losses under the open at 127-20. Had you placed a tighter stop, or if you were impatient, you might very well have been stopped out on the first entry.

Click to Enlarge Chart

The reason I point that out is that this day shows an example of what I call a “second pass” entry, as the market traded back through first resistance about 7:30. It can be tough to get back into a trade if you’re stopped out on the first try, but I’ve often seen the second pass trade work well. After this second pass, bonds quickly trade up to the second resistance at 129-27, which was the first profit objective. After trading to second resistance, they trade back down to first resistance, giving a third opportunity to go long. After this support area held, bonds proceeded to race higher, hitting the final objective at 131-11, or a move of $2343.75.

In addition to illustrating trades, note how Trade or Fade’s support and resistance points actually do serve as support and resistance throughout the day. Resistance points did turn the market back three times in the session, and R-1 served as support later in the session.

Click to Enlarge Chart

By being able to anticipate the direction of the change in a market’s volatility, we can get an edge in determining future market direction. Having this information helps you to anticipate where a market may go, rather than leaving you to react to market moves. In addition Trade or Fade takes away the guesswork of finding entry and exit points.

Click here to receive complimentary two-week trial to my Trade or Fade Advisory and copy of the Trade or Fade user manual.

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