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Tales of a Technician: Volatility Rotation

March 5, 2019

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Stock prices are cyclical. But so too is volatility. Just as prices rotate between bull and bear markets, volatility transitions between expansion and compression. Today I’ll show you how and highlight a current setup in Amazon that was mentioned in this week’s Options Report.

Volatility Compression

Volatility Compression

A volatility compression goes by many names including consolidation, a base, a coiled spring, nap time, digestion. Sometimes these episodes form easy-to-spot price patterns like triangles or boxes. They all represent a pausing period where the stock can catch its breath after a substantial move. This is where overbought or oversold conditions ease and a foundation is laid for the stock’s next launch.

Think of compression as a stalemate between bulls and bears. Buyers lack the vigor to push to higher prices while bears prove powerless to spark a sustained down move. Typically, prices will meander until one side in the contest finally proves victorious

Volatility Expansion

A volatility expansion is nothing more than a strong directional move that breaks away from a well-established base. It typically carries increasing momentum and pushes prices well into overstretched territory.

The aim of some traders (like our very own Breakout Frank) is to spot stocks poised for expansion and climb aboard just as the rocket ship takes off.

Virtually every stock follows the playbook of alternating between compression and expansion. A large price move eventually gives way to digestion. And digestion sows the seeds for the next big price move. And round and round it goes.

Bollinger Bands – The Ultimate Volatility Indicator

Perhaps my favorite indicator to measure the existence of volatility rotation is the Bollinger Bands (BB). Otherwise known as “adaptive volatility envelopes,” the BB consist of an upper and lower band set around the 20-day moving average. The distance between both bands expands in periods of increasing volatility and contracts in times of decreasing volatility.

The pinching together of the bands is what confirms that a period of volatility compression is upon us. Some traders look for this signal when identifying stocks that are rested, and perhaps ready to bust a move.

Pinching Amazon ($AMZN)

$AMZN Bollinger Bands

The accompanying chart of AMZN highlights three instances where the BB tightened considerably. The first two preceded strong directional moves in the stock. Will the third do likewise?

This is a situation where bi-directional trades like straddles/strangles, inverted flies and debicons might make sense. But, since all four of these curiosities are long vega, they also do better in a low implied volatility environment (i.e., when options are cheap). If we add on the IV rank indicator, you’ll note Amazon’s volatility sits at 25% or the 28th percentile of its one-year range. While not the lowest we’ve seen, some would argue it’s low enough to justify a long volatility play.

$AMZN chart on TOS: Bollinger Bands, Implied Volatility and IV Rank

This is why AMZN was highlighted in last weekend’s Options Report as a volatility idea.

Another alternative exists. Rather than going bi-directional you might wait for confirmation that the stock has chosen a direction for the volatility expansion and then place a trade betting on continuation in said direction.

For example, with Monday’s jump, AMZN could be hinting at an upside breakout, making bull call spreads an interesting idea.

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