In the first blog in this new series for beginning traders/technical analysts, I suggested that the first goal of chart analysis is to understand the most likely emerging volatility conditions. In this blog, we’ll dig into that a little bit more, and talk about how we actually accomplish this.
First of all, I should warn you that this will probably be the hardest blog in the series, especially if you are a newer trader. I hate it when people teach something and say “it’s so advanced you won’t understand it until a lot later.” In most cases, that’s just poor pedagogical technique because the teacher could have connected the dots better for the learner. However, this topic is a bit intimidating because we are thinking about the final goal of chart analysis—where you want to end up—and it’s hard to fully understand that at first.
Knowing where we are going will help you to structure your thinking about charts and technical analysis in general, so, read on and maybe just resolve to be a bit fuzzy on some of the details right now!
Though I defined it in the previous blog, I think it’s worth revisiting the concept of “volatility conditions” as this term is easily misunderstood. Volatility, in general, usually refers to how much price “bounces around” or how uncertain we are about where the market will be in the future. If we are highly uncertain because price moves around a lot, that’s higher volatility.
We can measure volatility many different ways. The default choice for much of technical analysis is average range (high – low of each time period) or average true range (range + any overnight gap from previous close). For more quantitative analysis, some variation of historical volatility (which may also be called realized or statistical volatility) is more common. Though there’s overlap here, they are also significantly different: historical volatility is blind to high/low extremes of the periods, while range doesn’t see the closes!
But what we are talking about here is not just if the market is going to be more or less volatile in the future. That’s part of it, yes, but the most important part is whether the market is likely to trade directionally or to mean revert. Is the market more likely to trend or go into a trading range? Is the market more likely to continue doing whatever it has been doing, or to do something different?
That’s really the key: are we entering an environment in which “go with” or “fade” trades will work best? Volatility itself is part of the concept: if we are entering a range, then volatility can generally be expected to decline. One of the ways we enter trends is with a volatility expansion that stays higher. If a market is trending, then much higher volatility, coupled with movement in the direction of the trend, can often mark and exhaustion point and end of trend.
Volatility plays into it, but it’s understand the type of trading that is most likely to come that really matters.
How do we do this?
I just wrote a heading that I can’t possibly deliver in a blog post! In fact, all of the hundreds of thousands of words I’ve written here and in my books, the days and days of webinars and lessons in the trading course and online, and all of the research I produce every day for my clients—all of that answers this question. In fact, all of the tools of directional trading really address this question. I can’t possibly answer it fully here, but I can give you some ideas.
- The first assumption should be that the market will continue doing whatever it has been doing in the most recent past. Unless something upsets the cart, expect current conditions to continue.
- If recent activity is an aberration compared to longer history (e.g., the past few weeks relative to the past year, or the past 15 minutes relative to a trading day for intraday traders) then expect that longer-term environment will try to re-assert itself.
- Watch to see how specific large moves are absorbed by the market. What if the market is trending and makes a large spike against the trend? Is that move quickly reversed or does it lead to more countertrend movement? What if the market has been ranging and makes a large move, perhaps beyond some obvious chart level? Is that move quickly reversed (via price rejection) or does the market sit there?
- Some of the chart patterns of technical analysis can be useful here, and these relate to consolidation after large moves. Many of the categories and types of chart patterns aren’t terribly important as standalone patterns, but they become very powerful when understood in this context.
This idea of watching price movement and creating various scenarios is another key skill for chartreaders, and that will be the topic for the next post in this series.