Are Price Spikes Ever a Good Thing?

11/03/2008 12:01 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

There is an interesting technical tool used by many traders to measure volatility called an ATR (average true range) indicator. As you can see in the chart below, the ATR applied to a weekly chart of the S&P 500 index. Usually, the ATR is relatively low during bull markets but will start spiking as the stock market reaches its peaks, destabilizes, and starts to fall. You can see how this information is useful for traders interested in knowing when they should control their risk. The ATR does this by measuring the average trading range over a period of sessions. The larger the trading range (up or down), the higher the ATR will spike. I have set this chart to use the average trading range over five periods or five weeks. Shortening the period will look similar but more volatile.

S&P 500 (SPX) weekly chart with 5 period ATR
chart

Volatility really means fast moves both up and down. What causes this uncertainty? Traders and investors are more uncertain than normal about where prices really should be, so the swings are wider than normal. Uncertainty is not a good thing for the market. Although a large one-day rally is emotionally satisfying if you are a bull, it is really just a signal that traders are still confused and risk is still high.

That doesn't mean that we should stay out of the market. In fact, it is quite the opposite-you should be in the market but you should be investing with the current environment in mind. That means that rather than taking on a bunch of long market exposure through some uncovered "stock bargain shopping," you should be selling covered calls, buying protective options, and emphasizing diversification and money management.

More aggressive traders may be using the current ATR levels to indicate the kinds of strategies they are using. For example, options straddles and strangles are usually much more attractive during these high-volatility periods because market crashes (up or down) can turn into profits very quickly. The important thing to keep in mind during periods like this is not whether the market is up or down big in one session. The important thing is to remember that it is moving big, and while that may be bad for bulls, it can be great for you.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

In the following video, I will show you how the ATR indicator works and how to use it in your own analysis.

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