Thursday, July 31, 2008

Cycles of Contraction and Expansion

The Stock and Futures Markets go through cycles of expanding and contracting volatility. Periods of narrowing volatility suggest uncertainty among market paricipants. Bulls and Bears, both are confused on the direction of the market. This state of indecision does not last long. One of these two groups is likely to get an upper hand. When this happens, volatility expands in the direction of the stronger hand. If the bulls are stronger, they will push the markets up, while if the bears get stronger, the market should see a sharp down move. The narrowing volatilty then is an indicator of an expansion in price range in any one direction. It is a setup where the trader can take a position in anticipation of an increase in volatility and a directional move.
On Thursday, the Nifty remained lock in a narrow range. This was the narrowest range in seven days. Just two days ago, the Nifty had a similar narrow range day. Two days of low volatility tell us that the market is ready for a period of expanding volatility. This should take place soon enough, with the Nifty likely to move sharply in one direction - up or down.

How to trade such cycles of contraction and expansion ? Two ways.
First, Using Options, buy a Call and a Put, then wait patiently for the expected increase in volaatility. When the market gives a clear directional break out, sell the losing leg and continue with the profitable option.
Second, wait for the actual process of expansion to begin. When the market does show its hand, moving decisively in up or down, then take a trading position.
Specifically, the Nifty is in a period of contracting volatility. We can identify 4350 as resistance and 4300 as support. A move beyond these levels will be the first sign that the Index is moving towards a directional move. When this happens, take a position in the direction of the breakdown / breakout.

1 comment:

Nawal Kamboj said...

Blog has very usefull information ,i have earlier mailed my enquiry regarding option trading stratagy ,after reading the blog i got some clarification (to sell losing leg on breakout)i request you to kindly also explain some more things,for example should we roll up or down the options