Being able to understand and capitalize on market volatility is an important skill for active intraday and swing traders to develop. Looking at the relationship between the NASDAQ Composite (^IXIC) and the CBOE Volatility Index (VIX) provides technical signals that traders can use to help identify core parts of a strategic trading plan.
Understanding High-Volatility Market Signals: What to Look For
One of the most important patterns to recognize in the NASDAQ Composite is “how far does it run in a single direction, prior to a retracement”?. In Figure 1, a 15-day candlestick chart of the NASDAQ composite, we can see that the maximum average trading range is approximately 60-70 points.
This index elasticity is similar in concept to “Average Trading Range” (ATR) based trading, but applied to the broad market. We can call this the “NASDAQ Volatility Range”, since it correctly shows the average number of points the index moves in single intraday or multiday moves. This is important to understand, because it shows us technical clues about how to potentially capitalize on volatility as it’s occurring each day.
In Figure 1, we’ve marked out 3 major moves, and as you can see, they’re all 60-70 points each. Now armed with this information, we can make better trading entry and exit decisions, for the next time the NASDAQ Composite starts to make what looks like a major move. If for example we sell the market on a loss of the 2980 (under the head-and-shoulders pattern at far right in the chart), then we can anticipate a maximum index move from (2980 – 70 points) = 2910 as technical volatility support.
So if we’re short in a handful of open equity trades, and/or long in inverse exchange-traded funds, during this drop, we know we should tighten in trailing cover stops as the NASDAQ gets close to the 2910 level.
How to Capitalize on Market Volatility
The CBOE Volatility Index (VIX) shows the market’s expectation of upcoming volatility, using a variety of S&P 500 index options. It moves up when the broad market moves down, as seen in Figure 2. Often referred to as the “fear gauge”, it’s a good sentiment indicator that spikes up, or trends up, as selling pressure moves into the markets.
To capitalize on volatility, one useful technique is to either short stocks or buy the inverse “bear” exchange traded funds–like Direxion Daily Financial Bear 3X Shares (FAZ), ProShares UltraShort QQQ (QID), iPath S&P 500 VIX Short-Term Futures ETN (VXX) and similar–when the VIX takes out new cup breakout highs, as seen in Figure 2.
Anticipating directional moves in the broad market by looking at how strongly the VIX chart is moving is one effective strategy that active traders can use to help gauge directional bias. The stronger the VIX cup breakout patterns are (as measured by increasing depth of the cups, in points), the more likely the market will continue to trend downwards.
Using the VIX to capitalize on market volatility also helps for traders who are swing or day trading, by helping determine how closely to place stops (either stop losses for open long positions, or cover stops for open winning short trades).
It’s also useful to determine major levels that other traders are likely to use for both the NASDAQ Composite (for example, 3000 is a key technical support/resistance level), as well as the VIX (in which 18 is a technical support/resistance level that can be used). Combining the signals from both broad-market moves as well as the VIX volatility index can help traders potentially stay ahead of reversals, and correctly trade breakouts and breakdowns based on volatility signals as described earlier.
Ken Calhoun is a trading professional who has traded millions of dollars of equities since the 1990s, and is the producer of multiple award-winning trading courses and video-based training systems for active traders. He is a UCLA alumnus and is the founder of DaytradingUniversity.com, a popular online educational site for active traders.