Raging inflation and more recently bank failures have added considerable volatility to many markets. There have been big swings in interest rates, which have a direct influence on equity indexes, currencies, precious metals and many commodities. Surprise events often bring on panic, which adds pace to market movement.

Just as traders seek ideal timing for entering a trend they must also identify when one is moving too far, too fast. When the speed of a rally or decline vastly exceeds the norm, odds increase for a period of consolidation or a reversal of direction. Thus, long option premium will begin to decay.

Trend and Consolidation

Prices trend, consolidate, trend and consolidate again. These phases are constant and repetitious in all markets. This is the circle of trading, and gauging speed is an integral part of developing trade strategy. Markets were created to facilitate trade. When a market moves in a direction and the day ranges and volume decrease it is not facilitating trade. As volume decreases opens and closes tend to be near each other (small candlestick bodies). Subsequently, a reversal often occurs. Another type of reversal comes when the pace of a rally or decline surpasses the average speed. This is commonly known as an overbought or oversold condition. Range length and angle of ascent or descent are the most basic tools for gauging an overbought/oversold situation.

Tools for Monitoring Speed

Many analysts use technical indicators to track the speed of a move. The most popular are RSI (Relative Strength Index), Stochastics and MACD (Moving Average Convergence Divergence). When RSI or Stochastics get above 80 a market is thought to be overbought. On the other hand, a reading below 20 signals an oversold situation. One problem with these indicators is that a market may hang around that 20 or 80 level for weeks. This makes timing a reversal a tough task. In fact, RSIs are more effective when used to determine trend strength. Stochastics are more reliable when looking for a trend reversal indicator. MACD may be used to determine when the speed of a move is too fast because the MAs are divergent. It may also be used to determine if a trend is likely to launch. When the MAs converge for a long span, odds increase for a breakout.

Average True Range Speedometer

Traders become more skilled at picking tops and bottoms if they are familiar with range length over many time frames. ATR (Average True Range) is ideal to keep these stats. By referring to benchmark ranges we can determine when the speed of a move has become too rapid, thus favoring a consolidation phase or possible trend change.

For a short-term gauge I often refer to an average day range over the past 20 days. If a day range spans more than 175% of the daily 20-day ATR in a 24-hour period, it is considered too quick. In this situation probabilities shift to favor a period of consolidation or change in direction. Another indication of a pace problem (overbought/oversold) is when a market has moved the length of an average week (9-week ATR) in a 48-hour period. Extraordinary ranges frequently occur as trends near exhaustion and subsequently are also common just before reversals.

Strategy Using Speed

If you prefer a contrarian approach when trading or if you prefer to sell option premium, search for markets that are overbought/oversold. Traders who prefer to write options should hunt for markets that exceed normal speed limits. Good timing can have a huge impact on profit and risk. Recognizing severely overbought/oversold signals will enhance your odds of picking off extreme highs and lows for both entry and exit trades.

John Seguin, Market Taker Mentoring