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Narrowing SPX Volatility – A Sign Of An Impending Breakout

|Includes: DIA, IWM, QQQ, SPDR S&P 500 Trust ETF (SPY)

By Christopher Diodato

This post is going to be much like the one posted in my newsletter last night, viewable here, but more focused on price. August has been a relatively quiet month thus far, and the market has continued to inch up. Meanwhile, with very little movement in the markets, volatility, measured as the standard deviation of past movement, has been very low. Of course, the VIX has also declined to very low levels. What does this mean?

Volatility, unlike stock prices, are mean reverting. That means that low volatility is followed by high volatility, and vice versa. Therefore, with low current volatility, higher volatility is expected in the future.

Here's a chart of the S & P 500 plotted with Bollinger bands (simply standard deviation bands). On the bottom of the chart is the distance between the top and bottom band. Notice that every time the distance declines below 10, the market tends to break out into a high volatility period over the next few months.

In trading terms, this is called a "volatility squeeze." It's times like this the option traders will begin making high volatility bets using derivatives. For an example of one strategy I intend to use, check out yesterday's newsletter. Happy trading!

~Chris Diodato