Friday, February 05, 2010

More on the Relationship Between Volume and Volatility

Traders typically try to anticipate market direction, but rarely do they attempt to forecast likely volatility. I'm increasingly convinced that the latter is as important as the former, as it tells you the price levels we're likely to hit in a given period of time.

As readers are aware, I use a market's relative volume as one way to gauge likely volatility for the day. On Thursday, for example, the day's volume in the ES contract not only stayed above its median volume throughout the day, but expanded its rise above the volume norms throughout the day. That told me that volatility was not likely to contract through the session.

Above we see how volume and volatility are related for the SPY ETF since August. The correlation is a very significant .78. How much business we do tells us something about *who* is active in the marketplace, and that tells us something about how much markets are likely to move.