Trading Around Volatility Transitions

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Back in April the market experienced a similar sell off for 63 points. What happened after the initial major down day was a few days of very large gaps (10pts and greater), before the market settled down and eventually resumed the up trend. Also in late February the markets went through a similar increase in volatility before stabilizing and continuing to the upside.

Ultimately there was shock from Bernanke’s comments about toning down QE and last night the Nikkei made a splash of its own. Which has put the market into a state of increased volatility and uncertainty in the short term. Ultimately there are two scenarios likely to unfold; the market remaining in a state of relatively high volatility, leading into a down trend. Or the market will stabilize and slowly revert to historically lower levels of volatility, possibly leading to further upside. Either way, we can expect a large trading range to develop over the coming days with plenty of opportunities to be both long and short.

My expectation today is for a gap size of roughly 15pts, which puts the gap fill below a 40% probability of filling. Typically expansion leads to contraction so I wouldn’t expect much today. I am going to sit today out, see how the market behaves around already established key levels and then proceed from there.