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.