Thursday, December 29, 2005

Narrow Trading Range Periods

My upcoming Trading Markets article will examine narrow trading ranges over a 20-day period, going back to 1990. I was inspired to take this look after receiving a number of emails from readers suggesting that we were headed for a major (upside) breakout move due to the extended narrow range that we've been in.

So my question was: Do narrow, rangebound markets lead to future price volatility and a directional edge in prices?

The gist of my findings was that low volatility 20-day periods in the S&P 500 Index tend to be followed by below-average volatility 20-day periods and high volatility periods tend to be followed by above-average volatility. Interestingly, the recent 20-day period is one of the lowest volatility periods we've seen since the early-to-mid 1990's--in fact, it's in the lowest 1% of all 20-day periods in my sample.

Compared to high volatility 20-day periods, low volatility ones were just as likely to be up vs. down over the next 20 days, but the average sizes of gains are greater following high volatility periods.

In short, historical analysis does not support the idea that narrow, low volatility markets lead to high volatility breakouts or that there is a distinct price direction edge associated with extended low volatility. My website does mention reasons for concern regarding weakness in the current intermediate-term picture, but this is a consideration specific to this market. History is not on the side of those who expect large, extended directional moves to emerge from low volatility markets.