I have received quite a few e-mails asking how to handle the current volatility; some e-mails also asked how I assessed the increase from 30% to 45% in the ‘ES 09-15-2008 III‘ piece.

Let’s take the first question. I have a rule which says that when we see ATR increases for 2 consecutive days (sometimes 3 depending on context) beyond mean + 2 standard deviations (stdev), and I don’t have a position, I am to stay out of the market. If I do have a position, I manage the trade in accordance with my rules which call for a reduction in size usually about 50%. These are the general guidelines. I may change them if the context demands.

Figure 1 shows the ATR and stdev for this structure, 23 ATR with a stdev of 10. In fact the ATR has remained consistently around 25 with a stdev of 10. On Monday Oct 15, we had a range of 58 just beyond mean +2 stdev; on Tuesday, we had a range of 46, below mean +2 stdev; on Wednesday we had 55 and yesterday we had 77.

Even though the market did not technically have two consecutive days with ranges greater than mean +2 stdev, the context persuaded me to exit all shorts. Apart from the volatility, we had a key reversal day off the 12-monthly swing 50% retracement and other price targets. This suggested a bounce of at least 13-week swing proportions and given the volatility I had seen, I was unwilling to hold any shorts.

Let’s now turn to the second question. The first part of the answer lies in the stats we have for reversal bars at 13-week swing and 18-day swing target zones. The stats suggest that if we see a reversal bar, there is 67% probability of correction; this goes up to over 80% , when we have a close beyond the Primary Zones.

In this case, the breakdown on Monday 15 caused me some concern. The move took place in the last 30 minutes and I believed we needed to see confirmation of the breakout, especially since the Market Profile showed a rotational day. I interpreted that to mean that there was buying support from which to base a reversal.

Instead of confirmation of the down move, we saw a reversal bar. However, before concluding a sustained bounce would ensue, I needed to decide on the amount of buying conviction the reversal bar exhibited. Given Monday’s range and volume, Tuesday’s range and volume were great. In addition we had not seen a buying conviction close above 1215, my first benchmark. Accordingly I concluded that I need to downgrade the significance of the Tuesday’s reversal bar: I did increase the probability for a bounce after Tuesday to 45% from Monday’s 30%. But note that this assessment is below the 67% called for by our research on reversal bars.

Yesterday’s bar on the other hand showed all the signs of a bear market bottom:

  • Climactic Volume & range and
  • A frenzied and fearful psychological environment
  • A Key Reversal Day

So, I’d rate yesterday’s bar as a 67% probability that a bear-market bottom that may hold well into the end of the year. The key will be the re-test of 1133 . If 1133 Primary Buy Zone can hold, we have seen a temporary bottom in place.

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Figure 1 ATR Range and Std

Figure 2 shows the 18-day targets for this rally: I have drawn the rectangle around the zones.

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Figure 2 18-day Targets

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