Friday, April 24, 2009

When Price and Volatility Move in Opposite Directions

Here we see the S&P 500 Index (SPY, blue line) versus the 20-day moving average of its daily high-low price range. Note that volatility, as measured by price range, continues to fall as stocks have moved higher and now sit in a multi-day trading range.

What makes breakouts from trading ranges so promising for traders is that they offer opportunities in which both volatility and price are moving directionally. Lately, we've been seeing volatility move opposite to price, which has created stasis.

Recall that the R1/S1, R2/S2, and R3/S3 profit target levels posted each morning via Twitter are based, in part, on the market's recent volatility. As volatility expands along with price, we have very high odds of hitting these target levels. Knowing this can help traders do a better job of riding their winners. Conversely, as volatility has been contracting, more modest profit targets become relevant, such as the overnight and prior day's high and low.