Timing volatility surges
07/03/18

The words “trading range” can make the eyes of some traders glaze over, since it’s sometimes interpreted as shorthand for “a market going nowhere.” Of course, a market going nowhere today could be tomorrow’s mover: Since volatility tends to cycle between highs and lows, low-volatility consolidations sometimes represent chances to catch a market that’s potentially setting up to make a high-volatility move.

One simple market situation traders often look for is a market that is forming a tight consolidation near the upper or lower boundary of a larger trading range. As an example, take a look at the following daily chart of internet domain registry firm Verisign (VRSN):

Verisign (VRSN), 10/27/17 – 6/26/18. Verisign (VRSN) daily price chart. Volatility breakout

Source: OptionsHouse

The stock formed a broad trading range from mid-March to mid-May, at which point it formed a much tighter consolidation at the top of the larger range. When the stock burst out of the upside of the small consolidation, it didn’t look back for the next three weeks.

In essence, what happened was that an up-trending stock formed a trading range—that is, a pause in the trend—and, when it pushed to the top of that range, it traded sideways in a tight consolidation instead of selling off again to test the bottom of the range. A few things to keep in mind when looking for opportunities like this:

  1. Trend extension: A trend is in effect until it’s reversed, and a trading range is a pause, not a reversal. Thus, all else being equal, many traders tend to expect prices to exit a trading range in the same direction they entered it—in this case, up. (If a market doesn’t break out the way it’s “supposed” to, some traders and analysts would view it as a potential reversal signal.)
  2. Sticking to one of the range boundaries instead of reversing: The fact that the stock didn’t turn down soon after reaching the upper boundary of the range (as it did in March and April), and instead formed a second, tighter range, suggested bulls were not ceding control of the stock to bears.
  3. Volatility is cyclical: Lower-than-normal volatility is often followed by higher-than-normal volatility, and vice versa. In this case, toward the end of the tight late-May consolidation, the stock’s 10-day historical volatility (chart bottom) had dropped to its lowest level in more than four years. So, the high-volatility breakout that emerged from this consolidation may not be so surprising.

It’s not critical that the second, smaller consolidation forms exactly at one of the boundaries of the larger trading range. The important signal is that price moves sideways instead of pulling back or reversing when they approach, or initially push past, the trading range boundary.

Cisco (CSCO), 4/24/17 – 6/26/18. Cisco (CSCO) price chart. Consolidations above range high

Source: OptionsHouse

For example, in the chart above, a few days after breaking out above the upper boundary of a nearly four-month trading range, networking tech company Cisco (CSCO) entered an even tighter consolidation in late-September 2017 as the 10-day historical volatility dropped to its lowest level in more than two months. Although CSCO immediately entered another tight consolidation when it pushed higher in late-October, the breakout that occurred in mid-November was followed by a high-momentum rally.

So instead of ignoring markets that have been stuck in ranges for a while, see which ones form narrow consolidations near their highs or lows. They could become a lot less boring before you know it.

 

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