Stocks & Commodities V16:7 (344-348): A Volatility Trade In Gold by David S.

Landry REAL WORLD

A Volatility Trade In Gold

Large moves often follow low-volatility environments. Heres one method of combining volatility indicators and pattern recognition along with trend-following methods to capture a breakout in the 1997 gold futures market. by David S. Landry, CTA simple review of a market chart will illustrate that markets trade in periods of lackluster sideways price action and then abruptly adjust to new conditions by trending to another price level. The goal of many traders is to trade these short-term trends profitably. Technical analysis can aid you in identifying potential trades based on the concept of the market moving from trading ranges to trends. To demonstrate, Ill walk you through a trade in the gold market based on a set of technical indicators. First, let me define the formulas I used for my analysis (see sidebar Formulas for the calculations). Having set up my indicators, lets walk through the steps for making a trade. The first step is tracking volatility. To measure volatility, I used four-, six- and 10-day historical volatility indicators inspired by the volatility work of Larry Connors. I added two

additional indicators to the historical volatility indicators. I ran an average of the three by adding each of the four-, six- and 10day historical indicators together, dividing by 3, then calculating a 12-day exponential moving average (EMA) of that result. A word of caution. Be careful when developing a derivative (in this case, averaging the three historical volatility readings) and then taking the moving average of that derivative. You may have created a more complex indicator that only introduces additional lag compared with the original indicator. Any time I start deriving formulas from formulas, I use them as supportive indicators and not as primary trading indicators. Finally, two other indicators I used in this trade were the one-day average true range (ATR) indicator and the 10-day linear regression line. The ATR calculates the true range by including the difference between the previous days close, if there is an opening gap, and the extreme price for the day instead of just the days actual trading range when measuring the days range. The linear regression line is a best-fit trendline calculated by the least-squares method. Both indicators are available in most major charting software packages.

ANALYSIS
According to Larry Connors and Linda Bradford Raschke, Large price moves occur when the six-day historical volatility reading is less than 50% of the 100-day reading. Take a look at Figure 1; the six-day reading is at 23.66% on April 10, 1997. Elsewhere, Connors also states that more powerful moves occur when multiple-period historical volatility readings are under 50%. Note in Figure 1 that on April 10 the four-day historical volatility reading was at 24.05%, the six-day reading was at 23.66% and the 10-day reading was at 49.22%. Not only are all of the volatility readings (four-, six- and 10-periods) below 50%, but the one-day average of the readings was at 32.31%, the lowest level of the year. In addition, the 12-day EMA of the

Extremely low ATR Low volatility

METASTOCK FOR WINDOWS (EQUIS INTERNATIONAL)

12-day exponential average

FIGURE 1: COMEX GOLD. On April 11, 1997, note how low volatility readings are. The blue, green and magenta lines represent the four-, six- and 10-day historical volatility readings, respectively. The dotted purple is the one-day average of the three indicators and the solid purple line is a 12-day exponential average of the oneday average.

FIGURE 2: COMEX GOLD. The average true range (ATR) is at 1.10, the lowest level of the year.

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Stocks & Commodities V16:7 (344-348): A Volatility Trade In Gold by David S. Landry

average volatility indicator has been dropping for approximately the last month and was also at its lowest level of the year. The ATR is an additional volatility indicator. In Figure 2, note that the one-day average true range was at its lowest level in months. The entire range for the day was only $1.10, a very narrow range for COMEX gold. Because narrow ranges are often followed by wide ranges, usually in the form of a breakout, the market was becoming a strong candidate for a trade. Finally, using classical technical analysis, a small symmetrical triangle formed between March 26 and April 10, 1997 (Figure 3). Symmetrical triangles usually predict

breakouts as two trendlines converging. The theory is that at the bottom trendline of the triangle, the bulls meet the top line, the bears, as the market nears the apex. When the bulls and the bears meet, one usually triumphs decisively over the other. Judging by the fact that the above-volatility indicators and patterns are all in agreement, a breakout appears to be inevitable.

CHRISTINE MORRISON

BUT IN WHAT DIRECTION?

The problem with a volatility setup is you know its going to move but you dont know how. Because of that, you must be willing to take a trade in either direction and be prepared to 2

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Stocks & Commodities V16:7 (344-348): A Volatility Trade In Gold by David S. Landry

FORMULAS
Historical Volatility: MetaStock: Name: Conhv4 Std(Log(C/Ref(C,-1)),4) / Std(Log(C/Ref(C,-1)),100) Name: Conhv6 Std(Log(C/Ref(C,-1)),6) / Std(Log(C/Ref(C,-1)),100) Name: Conhv10 Std(Log(C/Ref(C,-1)),10) / Std(Log(C/Ref(C,-1)),100) Name: Volatility 12 EMA Formula: ((Fml(CONHV4)+Fml(CONHV6)+Fml(CONHV10))/3,12,E) Linear Regression using Least Squares: (Available in MetaStock and TradeStation) Average True Range: (Available in MetaStock and TradeStation) The greatest of: The distance from todays high to todays low. The distance from yesterdays close to todays high. The distance from yesterdays close to todays low. Name: Avg3hv Formula: ((Fml(CONHV4)+Fml(CONHV6)+Fml(CONHV10))/3

The average of the three Historical Volatilities (hv)

get out quickly in case of a false breakout. Before going into a volatility trade, I always put together a general framework on market direction. This way, if you take the trade opposite of your analysis, you know that the market should break out strongly. This breakout should be strong enough to negate all technical factors pointing in the opposite direction. Figure 4 shows that the price ranges are below the 20-day EMA and the slope of the average is negative. In addition, on April 4, 1997, there was a 2/20 EMA breakout sell (short) setup that was still valid as of April 10. (See sidebar 2/20 EMA breakout system defined.) I normally dont trade the 2/20 setup directly in the gold market but find it more useful as a confirming indicator. This helps to create a synergy approach, where combining a setup within a larger system helps to create a higher probability of a successful trade. One additional observation. If you plotted a 10-day linear regression within the symmetrical triangle (Figure 4), you would gather two additional pieces of information: First, the angle or slope of the regression line is relatively low, which further

confirms all of the other low-volatility readings, and second, the angle is down, which confirms a slight downward bias.

THE BREAKOUT
On April 11, 1997, gold traded slightly higher, trapping in a few longs as it rallies, only to reverse. I looked to go short if the market traded below the low of the previous day at $349.90. Gold then broke sharply, attracting new shorts as trend-followers entered the market. Within four days, gold was trading $11.40 lower from the day before the breakout, a 3.25% move. At this point, I began taking profits and scaling out of my position. My reasons to exit, other than just to take a profit, included a hammer candlestick formation on April 16, 1997, and a sharp rise and short-term peak in the ATR and historical volatility readings (Figure 6). The hammer is a one-day pattern formed when the market sells off sharply but recovers during the day. The theory is that the market hammers out a bottom as the selling pressure is exhausted, at which point buyers enter the market and bid the prices higher. Hammers

20-day EMA 10-day linear regression line 2/20 sell signal

Symmetrical triangle
Symmetrical triangle

FIGURE 3: COMEX GOLD. Here is a symmetrical triangle formed between March 26, 1997, and April 10, 1997. The top trendline of the triangle represents selling by the bears. The bottom trendline represents buying by the bulls. Both will meet at the apex.

FIGURE 4: COMEX GOLD. A negative slope in the 20-day EMA and the 10-day linear regression along with a 2/20-day EMA breakout sell setup suggests the breakout will be to the downside.

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Stocks & Commodities V16:7 (344-348): A Volatility Trade In Gold by David S. Landry

2/20-DAY EMA BREAKOUT SYSTEM DEFINED Buy alert: If todays low and yesterdays low is greater than the 20-day EMA. This signal remains valid until the low touches or falls below the 20-day EMA. Buy entry: Place a stop order 10 ticks above the two-day high. This will help ensure buying with the new trend and help to avoid false signals. Keep order until filled or as long as the buy alert is still valid. Long exit: Place a stop equal to the 20-day EMA. Continue to update this stop daily to form a trailing stop. Sell alert: If todays high and yesterdays high is less than the 20day EMA. This signal remains valid until the high touches or rises above the 20-day EMA.

2-day bar buy alert

2-day bar buy entry

Notice that the lows do not touch the 20-day EMA

Place stop order 10 ticks above the 2-day high

20-day EMA

20-day EMA

2-day bar sell alert

20-day EMA

2-day bar sell entry

20-day EMA

Notice that the highs do not touch the 20-day EMA

Place stop order 10 ticks below the 2-day low

Sell entry: Place a stop order 10 ticks below the two-day low. This will help ensure that you will sell with the new trend and help to avoid false signals. Keep order until filled or as long as the sell alert is still valid. are a good pattern for predicting the end of a short-term trend. The sharp rise and peak in average true range and volatility confirm that the move from a low-volatility environment may be over. Volatility is cyclical in nature; high-volatility environments follow low-volatility environments. Once the volatility indicators rise sharply, its often a good idea to exit and wait for the cycle to start all over again.

Short exit: Place a stop equal to the 20-day EMA. Continue to update this stop daily to form a trailing stop.

AND FINALLY
When trading a volatility situation, you must be willing to take fast, quick profits. If you are trading multiple contracts, you should at least begin scaling out on these large-range moves. Be careful not to turn a short-term trade into a longterm, big-picture scenario. Its fine to push your luck with a portion of the position for another few days, but remember:

2/20 setup

4/11/97 Breakout & 2/20 short

Peak in ATR Peak in historical volatility readings

Hammer Hammer

FIGURE 5: COMEX GOLD. On April 11, 1997, gold breaks out to the downside. Notice the 2/20, a confirming indicator in this case, is now short. Within four days, gold is trading more than $11.00 lower.

FIGURE 6: COMEX GOLD. Short-term peaks in ATR and volatility readings, coupled with a hammer on April 16, 1997, suggest the breakout move may be over.

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Stocks & Commodities V16:7 (344-348): A Volatility Trade In Gold by David S. Landry

the reason you entered the position in the first place was for a quick, fast move. David S. Landry is a Commodity Trading Advisor and president of Sentive Trading. He has a masters in business administration and an undergraduate degree in computer science.

REFERENCES AND RELATED READING

Achelis, Steven B. [1995]. Technical Analysis from A to Z, Probus Publishing. Connors, Larry A. [1996]. The Professional Traders Journal, Volume 1: March, Oceanview Financial Research. _____ [1998]. Connors on Advanced Trading Strategies, M. Gordon Publishing Group. Connors, Laurence A., and Linda Bradford Raschke [1996]. Historical volatility and pattern recognition, Technical Analysis of S TOCKS & C OMMODITIES , Volume 14: August. Crabel, Toby [1989]. Opening range breakout, Technical Analysis of STOCKS & COMMODITIES, Volume 7. Landry, David S. [1996]. The 2/20-day EMA breakout system, Technical Analysis of STOCKS & COMMODITIES,

Volume 14: December. Merrill, Arthur A. [1988]. Fitting a trendline by least squares, Technical Analysis of STOCKS & COMMODITIES, Volume 6: July. Natenberg, Sheldon [1994]. Option Volatility & Pricing: Advanced Trading Strategies And Techniques, Probus Publishing. Nison, Steve [1991]. Japanese Candlestick Charting Techniques, New York Institute of Finance/Simon & Schuster. Raff, Gilbert [1991]. Trading the regression channel, Technical Analysis of STOCKS & COMMODITIES, Volume 9: October.
See Traders Glossary for definition
S&C

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