Tuesday, March 10, 2009

The Power Measure: Trading With Direction and Volatility on Your Side

Think of the market as having two moving parts: one is direction, which is always up, down, or sideways in varying degree. The other is volatility, which is always volatile, quiet, or in between again in varying degree. The key to making significant money is to enter directional trades when volatility is also moving your way. In other words, if volatility is expanding as directionality is increasing, you have the makings of a significant trending move.

Above we see a variation of my Power Measure, which tracks the correlation between the directional movement of each bar and the absolute size of that bar. When tracking intraday shifts in direction and trend, I use a moving 20-bar correlation of five-minute data. The underlying logic of correlating price and range, however, is useful across time frames.

Notice how the correlation has stayed positive for much of the day, particularly since the market open at 8:30 AM CT. Indeed, the expansion of the Power Measure as we were breaking above multi-day support was helpful in identifying the nascent trending move. In gross terms, what the Power Measure is indicating is whether the market's "big bars" are predominantly occurring in one direction. When that is the case, it generally means that there is meaningful volume (i.e., institutional participation) and momentum behind the move--and that's worth respecting.