From the November 01, 2005 issue of Futures Magazine • Subscribe!

Volatility cues can lead equity prices

There are many daily trend analysis tools, such as the relative strength index (RSI) and moving average convergence-divergence (MACD), that can effectively predict a coming change in price direction in a traded equity. However, the change may take more time than a short-term investor is willing to tie up capital.

There is a better way to trade the markets short term. The volatility oscillator can be used as an indicator for change in price direction of an underlying equity through days instead of weeks.

By observing the volatility of the underlying equity’s price movement, the sentiment of that underlying equity can be teased out, especially when low volume or lacking news fails to reveal a price trend.

The volatility oscillator is composed of three factors: the daily change in the closing price, the five-day average of daily closing price changes observed, and the daily change in the standard deviation of the 10-day average closing price:

Volatility =

STD[mean(day^1:day^10)] ñ

STD[(mean(day^0:day^9)]

Price Change = day^1 – day^0

Five-Period Moving Average =

mean [(day1 – day0):(day5 –

day4)]

Closing Day Price = “day^x”

The volatility oscillator can be used to determine a near-term change in price movement by observing the change of standard deviation from the 10-day price mean (volatility) compared to the change in closing day price (price change) of the underlying equity.

When the trend of price change increases or decreases, and the trend of volatility moves in the same direction as the price change trend, the price trend appears to continue in the current dominant direction. A positive reading for either trend when graphed is a value above 0 on the y-axis.

A divergence in trends also can indicate a change in sentiment. When the price change is at a high level and volatility is at a low level, in relationship to the standard deviation of the points graphed (a high level being above half of the standard deviation), the trend tends to reverse to a series of price movements in the opposite direction. A reversal will be indicated by a clear divergence in the graphs, the distance of divergence determining the strength of the change in trend.

If the underlying equity is in a narrow trading range, the price change and volatility trends may not move enough to provide a clear sign for trade entry or exit. Therefore, observing the five-period moving average of the price change trend on the graph (the five-day price change average) along with the other two graphs will help guide that decision. Relevant periods of this are indicated by the bold circles in “Moved to action.”

Most often, when the volatility and price change both move to the opposite side of the y-axis, across the zero line, there has been a clear change in the trading sentiment. However, when there is low volatility and price change, the direction of the five-day price change average can clue the trader to trade entry or exits.

CROSS MARKET ANALYSIS

The volatility oscillator works equally well with futures and stocks. “Moved to action” shows the price change (green) of Rambus Inc. (RMBS) compared to volatility (blue). Green arrows annotate volatility increasing with the change in price above the zero line on the y-axis indicating a positive change in sentiment toward the underlying equity.

A long position would be opened at the points indicated by the green arrows, with a short-term expectation of offsetting that position when the cycle exhausts itself. These points are marked by the red arrows. In other words, as volatility becomes negative with the change in closing price, you should offset any open positions.

In a trend of little change between volatility and daily closing price, as seen with the bolded circles in “Moved to action,” observing the five-period moving average of the daily price change vs. the daily price change itself provides a clear measure of the speed of the price trend. It can help you determine whether a small trigger indicated by the graphs would warrant closing a position.

In both cases highlighted in “Moved to action” although volatility and price change signal a possible change in sentiment by both moving below the zero line, the change is relatively small and the five-day closing price trend is becoming positive. An entry or offset would be premature.

“In the market” shows the actual market price movement of the trade using the oscillator. The points annotated in “Moved to action” are mirrored in “In the market.” The trades are based on execution at the closing price. For a long strategy executed per 100 shares: from March 17 to March 28, it earned $1.63 per share; $0.77 per share from April 19 to April 28; and $1.11 per share from May 6 to May 24.

Divergence annotated by the blue and orange arrows in “Over and above” (below) for Juniper Networks (JNPR) also shows a shift in sentiment toward the underlying equity. These are easy to spot using the oscillator and show a clear reversal in short-term sentiment. As a rule of thumb, if the level of divergence is greater than 50% of the entire data set’s standard deviation for volatility and price change, the trend reversal is imminent.

“Over and above” shows the initiation of a strategy by the divergence in graphs for shorting the underlying equity. The strategy is cycled by using the 50% rule of thumb. Orange arrows indicate a signal to offset a short or open a long due to divergence. The circle indicates heavy volatility in the underlying strategy.

“Price payoff” shows the actual movement of the trades following the analysis based on the oscillator. The points in “Over and above” are mirrored in “Price payoff.” For a shorting strategy per 100 shares used from March 17 to March 22, we made $1.10 per share; $0.40 per share from March 24 to April 13; $0.97 per share from April 14 to April 15; $0.04 per share from April 22 to April 29. For a long strategy per 100 shares used from March 22 to March 24 we made $0.83 per share; $0.46 per share from April 13 to April 14; $2.87 per share from April 15 to April 22; $3.32 per share from April 29 to May 26.

“Farming for profits” shows the volatility oscillator at work in the wheat market. This shows the July 2005 contract traded from Feb. 25, 2005 to June 6, 2005. The strategy is initiated and traded based on divergence. The buy orders are indicated by the orange arrows and the sell orders are indicated by blue arrows. We exited the wheat trades when both lines crossed the zero line of the y-axis.

Here are the profits/losses for wheat, based on reversing each position. These are reported as dollars per contract, traded throughout the period stated: $325; $2,137.50; -$200; $62.50;

-287.50; $25; $387.50; $937.50; $1,450. The total profit for the period is $4,837.50 per contract traded.

KEEPING PERSPECTIVE

It is important to realize that the model can break down when news is released that shifts sentiment toward the underlying issue, such as a sudden uprising in the Ivory Coast if you are a cocoa trader, or an opening of an Securities and Exchange Commission investigation into a company in which you may be trading stock.

The JNPR long strategy that took a loss was due to a major shift in market sentiment, where the Dow rose from 10507 to 10567 and then fell to a low of 10355 before settling at 10407. The change will either support the trend originally indicated, or move the trend into a clear new direction. Under current subjective observation, if the five-day moving average of the price change is strong, the underlying sentiment should prevail regardless of the news.

A simple set up for this method is to download the price history of the equity desired and paste the date and closing price onto an Excel spreadsheet, sorted in ascending order. Starting with the 10th row, create two more columns, one for the moving average and one for the standard deviation of those 10 closing prices. Then in the 11th row, start a fifth column to track the difference between the price change of mean day (10) and day 11; this is the price change. In a sixth column, calculate the difference between the standard deviations in rows 10 and 11; this is the volatility. Plot the price change against the volatility, and select a five-period moving average for the graphed price change.

In “Big enough,” if the price change moves above or below the zero line on the y-axis of the graphed volatility oscillator at a magnitude of 23 or greater, and volatility moves by six or more in the opposite direction, the divergence is the result of a change in sentiment toward the underlying equity; however, it may be temporary if the five-day price change average is not indicating a change in sentiment.

Of the two signals the graph displays – crossing of both trends across the zero line on the y-axis or divergence – the crossing over the zero line is the dominant signal, as it typically signals a more extended change in trend.

Regardless, the trader should have clear-set goals when he enters the trade. This tool can help you determine if that goal was met to satisfaction. The volatility oscillator works well for futures and stocks on a relatively short-term daily basis; however, it has not yet been tested on other time periods such as monthly, weekly and intraday.

Geoffrey Dennis is a molecular biologist and a private futures and stock trader. E-mail him at geoffreydennis@yahoo.com.

Comments
comments powered by Disqus
Check out Futures Magazine - Polls on LockerDome on LockerDome