Normal correlations between stocks and other assets haven’t been reliable over the last two months. Even stocks that are generally correlated are behaving strangely as they diverge from each other, and investors are having to dig even deeper to speculate about the underlying macroeconomic issues that are driving prices.
We argued last week that the macro issues in the market that are most likely creating this flat trading are distortions produced by the actions (or threatened actions) of the big central banks.
That uncertainty is affecting the behavior of the big private investors and thinning the market. For example, a Goldman Sachs analyst appeared on CNBC on Tuesday with a 55% estimated probability for a September rate hike. One day later, on Wednesday, economists at the same firm reduced their expectations for a September rate hike to 40%.
When fundamental estimates are this volatile, technicals are probably the most helpful tools for making projections. However, even technicals will be limited until a breakout actually occurs.
What to Do
A good way to measure volatility compression and identify breakouts is by using Bollinger Bands, which squeeze together when the variance in an index shrinks. A breakout from a squeeze usually occurs in two short-term phases: The first phase is a rise in volatility when the Bollinger Bands start separating, and the second phase occurs when the price closes outside the upper or lower band.
In the chart below, you can see a recent squeeze breakout on the S&P 500 that resolved in the direction of the first close out of the Bollinger Band range. While this is a negative example, keep in mind that the odds of a positive breakout are still just slightly below 50%.
We are commonly asked if there is any way to tell whether the volatility breakout is more likely to occur in one direction or the other.
Unfortunately, unless the index is at a strong support or resistance level, there isn’t much we can do in advance to predetermine the likely direction. That is a disadvantage, but it doesn’t negate the fact that once the breakout occurs, the majority of the move is usually still ahead. That gives traders a chance to get in at the beginning of a short-term trend, which is especially advantageous to option traders.
In the meantime, we are still playing a waiting game.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.