Here's a way to buy volatility or to hedge a long portfolio by Grant C

Many investors hold long positions as August ends--some because they sell calls against stock, others because of asset allocation, still others because they aren't paying attention, etc. For those thinking about hedging a long portfolio, here's an idea that might help. For others, like myself, who are die hard volatility traders, this idea will work almost as well as options or inverse index ETFs. The VXX is the ETN of the VIX and trades about 3X the S&P. The common method of measuring volatility in the stock market is the VIX, an index based on a ratio between purchased calls vs. puts. Mostly the VIX declines when the market either rallies or goes into a period of complacency or reduced movement. Sort of what happens during the summer months as the big boys go off to the Hamptons to relax. Eventually, they come back and more often than not, they reverse August's action and jam the market into a decline. The VIX, and the VXX, goes up as a sort of "Fear" indicator (more puts being purchased than calls). This is how the Sept-Oct. period got the nick name of the "Death Season". Now, I have no idea if history will repeat itself and fireworks will replace August's inaction, but it is my nature to bet against the extremes. Since the market is at an extreme with complacency or lack of volatility, I'm interested in the other side of that trad, and will use the VXX to implement that strategy. The one thing I've learned about volatility is that it is "extreme" reverting, not "mean" reverting as most of the trading books claim. Price is much more likely to revert to the mean, or an average, and volatility seems to seek the extremes, sort of like water in a pan that is tilted back and worth so it laps at the edges.

A Question of Volatility - from David L

Market Behavior

I am a new but active trader, both with day trades and swing trades daily. In developing my trading skills, I have noticed a recurring pattern and am interested in what the behavior is behind it.

This week, I had a good trade with Nabors Industries (NBR.) I went in , short, Thursday afternoon when it was testing resistance at the $19.15 level. There was tremendous buying pressure throughout the last part of Thursday, with a clear sell-off late in the day. I held off taking profits, given the sell-off pressure, to take my exit Friday morning. The wait was well worth it, with the stock falling in early trading to below $18.00. I took my profit and did not look back.

My question for the group is this - I have noticed this type of price pattern with some regularity - very strong buying one day, with very strong selling the next. What is the basis of this behavior?

As a novice, I am assuming, a large fund or arbitrage has approval to buy a lot of stock in a particular range and does so on a particular day. Within this buying there are a lot of shorts riding the upward pressure. Then the next day the shorts are taking their profits - as I did. However, the sell-off the following day is at a much larger volume than I would expect. Is there something else going on in this pattern? I have made several successful trades following this pattern, but I would feel more comfortable if I understood the reasons for such price swings over two days - often without any news releases tied to the swings. Any suggestions are appreciated.

David L

Those sweet little triangles by Grant C

I'm curious by nature; which is often a flaw as a trader, when precision and timing mean more than flights of fantasy. However, over the years my curiosity has lead me into a very fertile area of inquiry for trading--volatility. For trading, volatility usually describes violent and quick changing price moves--think long bars on a price chart, not nice tight narrow-range ones.

Volatility is usually a function of emotion overruling reason, and therein lies profit. Good traders are creatures that understand fear and greed; profitable traders soon figure out ways to exploit this constant conflict in market behavior. The other extraordinarily profitable characteristic about volatility is that, unlike price, which follows a bell-shaped reality and is given to mean reversion, volatility is extreme reverting. This is probably worth repeating, because there is definitely money to be made in this insight (which comes from John Bollinger, BTW), volatility is extreme reverting, jumping from wild swings and long price bars to sudden pauses and short price bars, not a gradual sequential progression at all.

The chart of CAL clearly shows this behavior. Look at the bars on the right side, several long bars separated by three relatively narrow bars, which I've marked off with lines--looks like a small symmetrical triangle, doesn't it? Well, it does and it is exactly that, a period of indecision or confusion. Traders conflicted that the long move down from 21-16 was a trend, or an oversold buying opportunity. This push-pull tension went on for three days right at the 200 DEMA (red line), before fear overwhelmed them, the down move continued as the Bears took command and drove price to 13.

The sell short point is at the break of the third bar, a dime under the low or around 16.48. Since these little triangles, or consolidations, or continuation patterns, show up about half-way in a move, the target is sub 14. In my case, I closed out my position at the end of the first down bar, about 14.5. Notice that volume contracted during the triangle, and exploded as price fell out of it--classic behavior as fear set in once more.

I look for all sorts of volatility contraction set ups--triangles, squeezes on the daily charts, but really like them on the weekly or monthly charts. These little battles between fear and greed usually show up half way through a move and routinely make money. I take them in either direction, but especially like them to appear near 200 DEMAs where the big traders and hedge funds like to hunt--just slip into their wake; but remember to jump first before they reverse direction.

Trading False Breakouts - the DAG Trade

DAG, the quintessential “Little Worm” trade
by Grant C

Grant C is a long-term Spiker. He started out as a Spectator, was promoted inot the Spke group, and won a number of quarterly championships.

Click on the chart to enlarge it
Both Alex and Kerry have commented on the dynamic occasionally found at the end of long and brutal stock declines, when at the last gasp, a stock will slip through final support, then for some unfathomable reason reverse back in a failed break of support. It’s been called a “Little Worm” trade because when you see it on a six-month daily chart, it looks like a little worm poking through a floor bottom, then pulling back. My twist on the trade comes from the added move outside a volatility band (Bollinger Bands), or beyond two standard deviations from a 20 EMA (normal value). These outlier moves beyond the bands, or price envelopes, often set up a snapback dynamic that Alex commented on in a recent webinar.

DAG is a double beta (moves twice the underlying index) ETN of a basket of basic agricultural commodities—wheat, corn, soybeans, etc. Like most ETFs or ETNs, DAG will trend nicely and together with its opposite number AGA offers a way to trade both sides of the ag softs without getting involved with the futures market. A word of caution—they are fairly new and the daily volume can be low, so take small positions, use limit orders on entries, and get out on a rising market.

I was first long AGA as it broke to new highs in early December. The highs were made with a low-energy MACD-H push so I decided to bail. Then it occurred to me that DAG—its opposite—might be setting up in a MACD-H bullish divergence reversal. Sure enough, it was, so a couple of days later when it slipped through support at 8 and closed outside the lower band, I started to wonder if we were setting up for a failed breakdown and reversal. The next day price pushed even further outside the bands, and my short-term indicator crashed to an extreme low, but MACD-H barely dropped below the centerline. The bullish MACD-H divergence was in, and on the third day, when it popped up and closed on its high, inside the band, I grabbed my position on the close. I figured DAG might be good for a quick run back to the declining 20 EMA, which would be resistance. I sold it on an expanded-range day at the EMA three days later.

This was a clean, classic “Little Worm” trade that offered a fair return at minimal risk, and illustrates a very common price dynamic—reversion to the mean from an overstretched position. Eventually, we’ll get another trade out of DAG, and AGA, but for now we’ll go hunt fat rabbits in another part of the market.
The Little Worm trade also works on tops—see the Qs late October 2007 top with a huge bearish divergence.