Volatility Tales

After weeks of painting higher highs and higher lows equities are now in the process of completing a sideways week. It may have come to your attention that the current formation is starting to resemble that of the August advance which, albeit being smaller, ended with a plateau and then proceeded to drop lower. In September we got a dip lower followed by a quick blow off top – after which the second shoe dropped with a vengeance. Should we expect the same?

I’m afraid not – unfortunately the tape rarely repeats itself. It rhymes to some extent but rarely is it following an identical script. Because if you look under the hood the conditions right here are completely different than what they were in late August.

The tale I am about to tell is that of volatility and how it goes through cycles. To visualize the concept I will be using two of Ken Long’s indicators – VolStat to plot volatility and StretchStat for direction/momentum. Let’s start with the spoos but we’ll peek at a few other major markets as well as they are loosely connected.

If you look at the indicators on the charts above you see Bollingers giving us some sense of what’s normal, what’s above normal and below normal. Bollingers are a wonderful tool for that in that they use standard deviation to give us some sense of context. And that is very helpful for our human perception is easily manipulated.

In early September what you see is a gradual but steady increase in volatility (lower panel) which was accompanied by a lot more whipsaw (i.e. longer candles, longer tails, less direction, and fast drops/advances). Volatility started to slowly drop off in mid October in the midst of the current advance. Right now we are basically back to where in early September but we are exiting a high volatility period.

High volatility period are rarely followed by more of the same – the odds now suggest low volatility activity. But that doesn’t necessarily mean sideways tape. We could easily just crawl higher all December while volatility paints new lows.

Low volatility periods are however rarely associated with sell offs – so this suggests that the odds for an extended sell off and in particular panic selling at this stage are pretty limited. It’s never off the table altogether but also considering where we are seasonally I would be cautious betting against the bull here.

Bonds are also now coming out of a high volatility phase and the expectation here is that we’ll see a bit more orderly tape for a while. This may be good for certain systems and bad for others. For instance CrazyIvan seems to be doing extremely well during high volatility periods while Thor has been pushing sideways for the past month. Which by the way is no coincidence and it’s the reason why I took a closer look at the situation in the past few days.

Now here is gold which is on the opposite side of the equation. It’s coming out of a sell off phase with medium to high volatility and in the past week volatility has started to explode. I think we’ll see more before we start seeing less.  So if you are trading the upside keep your stops very loose and let her run. She’ll try to to buck and throw you off the horse for sure – be prepared.

More on volatility cycles and a few setups below the fold – please join me in the lair:

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Bonus Chart:

FYI – on the VXV:VIX ratio chart we are in the upper range and the signal is a bit divergent now. I think the bulls would actually benefit from a little correction here. We need to shake off some of the weak hands so that we’re ready for the EOY bear hunting season! 😉

Well, it’s been a fun and profitable week again – but now it’s time for the Mole to crack open a bottle of Hefeweizen. See you all next week!

Cheers,