by Tyler Craig | November 12, 2013 11:23 am
Japanese stocks treated investors to a fireworks show of epic proportions earlier this year. From January through May, the Nikkei 225 Index rallied more than 50%, making it the envy of stock markets across the globe.
Then, things changed.
Following a swift 23% downturn in late May, the roaring bull market was lulled to sleep. What was once a thrill ride for volatility junkies became a boring old merry-go-round taking riders on a circuitous route to nowhere. Since the midyear drop, the Nikkei has done virtually nothing.
Ironically, now that Japan has onlookers convinced it’s stuck in perpetual pause mode, it might be high time for volatility to make a resounding comeback. At least, that’s what recent chart patterns suggest. Let’s use the WisdomTree Japan Hedged Equity Fund (DXJ) to analyze these intriguing developments.
The six-month consolidation in Japanese stocks has taken on the form of a classic symmetrical triangle in DXJ. As indicated by the two converging trendlines, this neutral price pattern is comprised of a series of lower pivot highs and higher pivot lows suggesting an increasingly exciting battle between the bulls and bears. The higher pivot lows reveal elevated aggression by buyers who are buying dips at higher and higher prices. The lower pivot highs reveal a comparable increase in aggression by sellers who are selling rallies in DXJ at lower and lower prices.
Of course, both conditions can’t last indefinitely. At some point, one group wins the tug-of-war, causing a breakout or resolution of the pattern.
From a volatility perspective, the symmetrical triangle displays an ongoing compression in price movement — a coiled spring, if you will. Since stock prices usually alternate between periods of volatility compression and volatility expansion, it’s a good bet the lack of directional movement in Japan is a precursor to a big move one way or the other.
Rather than guessing which direction Japan eventually travels, option traders can elect instead to play the potential for an increase in volatility by purchasing a DXJ straddle. The option straddle is considered a bi-directional, long volatility strategy entered by buying an at-the-money call and an at-the-money put. It’s designed to profit if the underlying moves a sufficient amount in one direction or the other or if implied volatility rises.
With DXJ trading at $48, you could buy the Jan 48 straddle by purchasing the Jan 48 call and Jan 48 put for $3.35.
The market currently is pricing about a 7% move in DXJ by January expiration. If you believe the resolution of the ongoing triangle pattern will result in a greater-than-7% move up or down, the long straddle should come out a winner.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
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