Aside from macro and technical forecasts, one of the more overlooked areas to examine this new year is the current volatility environment. How well the market will trend and mean revert should be considered when you are developing your trading plan for the year ahead. So with that in mind, I'm going to share my thoughts in this area.
First, I'm going to show a 10 year weekly chart of the equity markets, with the 5-week average range on the bottom pane:
The first area to note is the measured move, highlighted in blue. This study assumes that the move from the lows to the summer pullback will be roughly equal to the current move. The next area of resistance is around 120, and there is some significant confluence there. Considering the drop in momentum, I can easily see a much slower grind through these prices as the structural dynamics of the market are different from 9 months ago.
The next point to draw are the boxes highlighted in green. The most recent cyclical bull market ran from 2003 - 2007, but it was in the context of a few ranges. For example, nearly the entire year of 2004 was within a 10 point range, and with each catalyst there was a new range put in for several months.
Finally, we have the 5 period average true range. This measures the distance between the highs and lows of the weekly bars and is a trailing measure of volatility. We can see that during the entire cyclical bull market from 03-07 we were in a period of calm; when we started to breakdown in late 2007 we saw an expansion in price and we are now back to the previous bull market levels.
On the assumption that we return to the environment from 03-07, certain trading strategies that worked over the past 24 months will no longer be effective. More adaptive trading strategies based on simple mean reversion may start to outperform the momentum trading that has worked so well recently.
One more data point to watch: the straddle price for SPX December 2010 options. This will show you the market expectation for longer term volatility. Current ATM straddle is priced at 193.40, so that gives us an expected range of 956 to 1343.
So given the current technical landscape, do you think we will be outside of this range by December? Do you think the momentum will be strong enough to get us above those levels, or do you think we get a sharp reversal taking us below the summer lows? Those predictions I will leave to you, but your answers should tell you whether you should be bullish or bearish on overall volatility.
