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
robhanna@comcast.net

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.