To trend, or not to trend? – Volatility Trading Part 4

by | Oct 8, 2016 | All Articles, Technical Analysis

Read Part 1 | The sandpiper & Trading

Read Part 2 |  Redefining Support & Resistance

Read Part 3 |  Risk & Reward

If Shakespeare were alive today the classic quote from Hamlet might be: “To trend, or not to trend? That is the question—Whether ‘tis nobler in the trading account to commit or go flat . . . “

In considering suicide, we observe that Hamlet’s soliloquy is 287 words long. Given the length of his scrutiny, I think today he would be classified as having ‘analysis paralysis’. But hey—we’ve all been there—right?

I’ve no words of wisdom to offer poor Hamlet. However, I can offer a solution for technical traders.
I’ll show you the answer to better trend identification and analysis objectivity in a moment. But first, let’s review classic trend analysis.

Linear Thinking: a.k.a. Revenge of The Bots

Technical analysis is, by its very nature, the art of capitalizing on the price trend. It’s the underlying definition of most responsible texts on the subject. Identifying the beginning and end of a trend as early as possible is what really impacts the game.

Classically accepted trend identification is based on price extremes. The diagram below shows the two most common methods for identifying a trend. A series of higher highs (peaks) along with a series of higher lows (troughs) can define an uptrend.

Classic Trending

Following that logic, a higher high followed by a higher low, followed by a higher high can denote the beginning of the uptrend. Another method is to show that the extremes of the price action are following an upward sloping trend line.

The end of the uptrend can be said to occur when a lower high followed by a lower low is printed on the chart. These identification methods can be messy—and more importantly—eat up time to confirm.

But that part’s not really a problem. Long before you conduct your line-based analysis, the dreaded ‘trading bots’ have identified the possibility of a developing trend. Once that happens they start messing with you.

Trading Bots

Price will be forced down below a trend line so as to get visual traders to sell prematurely—artificially misrepresenting the other side of the market—and making liquidity for the bot to subsequently enter.  Bots are programmed to game linear logic and stay out in front of it. And as I always say, they don’t have emotions, take breaks, or need vacations.

Redefine Trend Analysis

Fortunately, Volatility-Based Support Resistance (VBSR) can change the way we identify and profit from trends. Two simple actions:

  1. Falling through Volatility-Based Support (VBS) usually means the beginning—or continuation—of a downtrend.
  2. Rising through Volatility-Based Resistance (VBR) signals the beginning—or continuation—of an uptrend.

You see it’s not like we’re completely throwing out the classic trend analysis methodology. Extremes are still used to identify trends.  
What’s different in today’s markets is that price extremes are not as relevant as they once were. It’s volatility extremes that matter most. Why? Because volatility is what maps directly to the microstructure of today’s post-crash markets. See my previous three articles for a deeper dive on this topic.

VBSR uses volatility extremes in lieu of price extremes. Simple.

Consider the chart of the US Generic Govt 10 Year Yield (USGG10YR) below. The 10 Year hourly chart is in a well-defined downtrend by any analysis method. On Sep 22, lower lows occur alongside price dropping through the VBSR support zone. Plotted over the price candles is a percent-swing overlay indicator set to a 1.5% reversal tolerance.

US Generic Govt 10 Year Yield (USGG10YR)

Note that price continues to fall through two more VBSR support zones. It’s the end of the downtrend, and the subsequent beginning of the uptrend that’s more interesting.

On Sep 29,  price spent four bars with significant activity inside the VBSR resistance zone—very bullish. On Sep 30 the 10 Year tests VBSR Support but cannot get into the zone—not very bearish.  These are important clues that price is range bound, but with more bullish strength than bearish.

Here’s where the chart gets interesting. On Sep 30 and Oct 3 price reverses to a new high without putting any new higher low. That stings if one is waiting for a confirmed higher low to determine a new uptrend.

The way to use VBSR to overcome messy trend analysis is as follows:

  • When price closes for three of the most recent five bars above the SR 3 line (top of the SR3/4 zone), an uptrend is beginning or continuing.
  • When price closes for three of the most recent five bars below the SR 6 line (bottom of the SR5/6 zone), a downtrend is beginning or continuing.
  • If price is contained between the SR3/4 zone and the SR5/6 zone, then it can be considered to be range bound and not trending.

In the case of the 10 Year above, the trend is confirmed on 9/3. Using the previous bullish push into VBSR resistance on 9/29 an earlier entry could also be warranted.

VBSR Assisting Qualitative Analysis

As of this writing, I’m the proud owner of some Monsanto (MON) stock—a long position. Monsanto has an offer from Bayer AG for a buyout of $128.00 per share, but is trading around $102.

There is great skepticism as to whether the deal will be approved by regulators. So do I hold for my 20%+ premium or sell now? To be, or not to be?

VBSR Assisting Qualitative Analysis

To me the situation is simple. The market has been digesting all manner of information from sources inside and outside.  Price support/resistance will guide me.

I can hold or buy. I will consider price direction and the time commitment of funds.

  1. If price begins to trend below daily VBSR Support, below $100, then I’ll know what well-advised insiders are currently believing–no deal.
  2. If price rises up to daily VBSR Resistance at $110, I may close my position so I don’t have to wait for the final 2017 regulator decisions.
  3. If price trends above that VBR Resistance zone, I’ll begin to feel more comfortable that I’ll get my $128 per share sometime in 2017—deal!

Volatility Extremes Tell Me No Lies

Being objective about trend direction with VBSR has advantages:

  • Simplicity
  • Mathematical based analysis using a sound basis within the Market’s Microstructure
  • Better Reward to Risk probabilities
  • No Analysis Paralysis

If you are interested in seeing how VBSR can help with your trading methods, contact the folks at Optuma. They can set up a trial of these tools to give you some very possible advantages that you’ve likely been wanting.

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Kirk Northington, CMT

Kirk Northington, CMT

Co-founder of Northington Dahlberg Research, LLC

Kirk is a co-founder of Northington Dahlberg Research, LLC and is a quantitative technical analyst. He is a member of the Market Technicians Association, and is a Chartered Market Technician.  Kirk is a frequently requested speaker on the topic of volatility trading and volatility based market analysis.

He is the author of Volatility-Based Technical Analysis: Strategies for Trading the Invisible, Wiley Trading Series, John Wiley & Sons Publishers; in which he pioneered new concepts in technical and quantitative analysis. Kirk has a BS degree from Nicholls State University, in Thibodaux, Louisiana. He has extensive experience in institutional market risk, process control system design, and software engineering.

2 Comments

  1. Hi, I can not find the VBSR anywhere. Is it available?

    Reply

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