Markets often make large moves out of low-volatility situations. Unfortunately, volatility doesn't project the direction of these moves. Below, I look at how to predict the direction using a recent volatility play in Advanced Micro Devices (AMD | Quote | Chart | News | PowerRating). To those new to volatility, you might want to read my three-part series on the subject before continuing.

Reversion To The Mean

As I've said before, the reversion-to-the-mean concept can best be described as a joke: "If you know someone who's normally 'mean' and then they are nice to you for a few days, chances are they'll revert back to being mean." In terms of volatility, this concept means that periods of lower-than-normal volatility are often followed by periods of higher-than-normal or more average volatility readings. Markets often make large moves as volatility reverts to its mean.

The Indicators

Extending the work of Sheldon Natenberg ¹, Connors and Hayward compared a six-day historical volatility (HV) reading to a 100-day historical volatility reading. They found that when the short term (six-day) reading dropped to 50% (or less) of the 100-day reading, a large move was imminent as volatility was prone to revert to its mean.

The easiest way of showing this relationship is to express the short-term reading as a ratio to the longer-term volatility. To create this ratio, divide the six-day HV reading by the 100-day HV reading. When this ratio drops below 50%, a large price move is imminent. This ratio (six-day HV/100-day HV) is used in the examples below. Again, refer to my three-part series (or the references listed at the end of this article) for more information here.

Which Way?

"The Connors-Hayward Historical Volatility System has an uncanny ability to predict major moves. Unfortunately, it does not tell you in which direction the move will be. Therefore, the strategy you select will depend upon the strategies and indicators you are comfortable with" ²

After reading the above about six years ago, I became inspired to study volatility. I sought out classical technical patterns and developed my own swing trading patterns to capitalize on this inherent feature of volatility. Below we will walk through my analysis of Advance Micro Devices (AMD | Quote | Chart | News | PowerRating), a stock mentioned recently in my Stock Outlook and Options Outlook.

Case Example

Notice the volatility of AMD, as measured by a six-day/100-day historical volatility ratio (a), dropped well below 50%. This suggested that a large move is imminent as volatility is prone to revert to its mean. As with any indicator, I always double-check price to make sure it is confirms what the indicator is telling me. In this case, notice that the stock had been trading in a narrow range. In fact, on a closing basis (historical volatility is measured by closes only) the stock had changed very little in seven trading days.

Now that we know a large move is imminent, it's time to began to put together a "game plan." Notice that the stock has recently doubled off its lows. This suggests that a uptrend is under way and that volatility and price would likely expand in the direction of the uptrend. Further, the stock had also formed a big picture cup and handle (not shown).

For the entry, I looked for the stock to take out the top of its recent range. Notice that on 02/14/2001 the stock traded above the entire recent range (a)--(the past seven highs) as volatility began to increase (b). This suggested that the stock would continue to break out to the upside as volatility reverted to its mean.

The following day the stock explodes nearly 8% higher (d) out of the range (b) as volatility (a) reverts to its mean (c).

As I often preach, money management is crucial when trading. This is especially true when trading low-volatility situations. As Forrest Gump says, "Trading is like a box of chocolates, you're never really sure what you going to get." Therefore, as soon as have a decent profit, you should lock in at least half and move your stop on your remaining shares to breakeven. This way, you have booked a profit and still have a chance, barring overnight gaps, at a "home run" on your remaining shares. See my money management articles for more details here.

Unfortunately, the breakout in our case study was short-lived. Notice below that the AMD gapped lower (a) and imploded over the next two days after its breakout of over 8%. As you can see, money management is crucial Without it, this trade would have resulted in a loss.

One last point, notice that the stock began to stall out right as the old highs were approached (b). This was another clue that a piece of the profits should have been locked in. Also, in February 2000 the bear market lingered on, especially in technology-related issues. Therefore, you should be quick to take profits on the long side.

Other Options

Those familiar with trading options know that low-volatility situations, especially for momentum stocks, often offer opportunities. It's beyond the scope of this article to fully explain the complexity of using options in low-volatility situations. The following discussion assumes that you have a solid background in options.

As I pointed out in my Options Outlook on 02/13/2001, the AMD February 25 call options were trading around .30. This was fairly priced based on the implied volatility of the options compared to the longer-term historical volatility of this stock. Trading these out-of-the money options near expiration is known as a "gamma play" as the potential exists for a large change in delta. The risk of course, is that many times, short-dated options expire worthless (as we will see below). Professional option players know the dangers of these options and often say: "gamma get-cha." Therefore, only risk capital should be used in these situations.

The Feb. 25 call options skyrocket over 500% as the stock breaks higher (see above charts) At this point, if you played these options, you should have locked in a significant portion of your profits, especially when you consider that they only have one day left until expiration. Finally, as you can see in the above charts, these options expired worthless as the stock drops below the strike on expiration. This provides another example of why money management is so crucial. Normally when playing options, I look to lock in at least half of my profits as soon as the options double in value. I then look to scale out of the remainder of my position.

Final Thoughts

To those new to using volatility in trading, I realize that these concepts can be somewhat intimidating. However, I can assure you that it's well worth your effort to learn them. Therefore, I suggest you read my articles on volatility under Trader's Lessons and refer to the references listed below.

¹ Option Volatility and Pricing Strategies, Sheldon Natenberg.
² Investment Secrets Of A Hedge Fund Manager, Connors and Hayward

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