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The Coil is About to Spring


You wanna bet against ME when things are looking so rosy?!


Volatility is the lifeblood of markets - without it, there is a reduced opportunity for profit. It is also a reflection of the prevailing attitudes of participants. Most of us know about the VIX indicator, which shows us how much options traders think the S&P 500 will move over the next month.

There are innumerable ways of measuring volatility. One of the simplest is just looking at price itself. Doing so, we can quantify the range that the markets have been in lately.

Take the Nasdaq 100 (NDX) for example. Over the past three weeks, that index has not moved more than 2.2% from low to high (using closing prices only). For that index, 2.2% is an extremely tight range - in fact, it has been less than 2.5% on fewer than 1% of the trading days over the past few years.

What's it mean? Well, I could give you the common wisdom, which is that low volatility shows that traders and investors are confident in their positions and see no reason to be aggressive in their trading - in other words, complacency. I happen to agree, but let's just look at what the market has done previously and see if that would support or rebuke that theory.

The chart below highlights the only other times in the past five years that the range has been this tight (the red circles on the chart).

Three weeks after these occurrences, the NDX was positive only 1 out of 17 days, with an overall average return of around -4%. After the June instance, the NDX dropped a quick 25 points, before recovering and actually showing a positive three-week return. Perhaps even more notable, the range over the next three weeks was nearly triple what it was over the previous three weeks - the coils got sprung.

The possibility that these low-volatility conditions represent complacency on the part of investors is confirmed by many of the measures I watch. I don't think we're seeing the type of rampant speculation that we saw at the end of 2003 and 2004, but we're definitely seeing the same kind of complacency.

Is it enough to put the brakes on this rally? I'm not sure. If this was anytime other than late December, I would likely be positioned net short at the moment. As it stands, I am flat - I'm uncertain as to how much the positive seasonality trade will play out, so I am trying to wait patiently for a low-risk entry and am just flipping short-term trades. While late December can show some extremely tight ranges, we're about as tight as it gets and volatility should pick up soon.

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No positions in stocks mentioned.

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