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Market Skill-Builder
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Distinguishing Reversals from Corrections (2)
Volatility Expansion

1b - 1) as evidenced by a sudden volatility expansion, against the trend:

A sharp break against the trend with greatly expanded single-period range. This type of action may (but will not neccessarily) follow-through with a succession of similar periods. Often caused by unexpected news which is perceived as being significant by the market.

This type of action is "tough-to-trade" because it can be followed by further volatile periods in either direction. Trading Rules:

• If carrying a large long position : cut back to more reasonable levels immediately "at market".

• Place a limit order to exit the balance of any long position and establish a relatively small short position 2/3 of the way back to the top.

• Place a "stop" order to exit the balance of any long position (without entering a new short position) if the immediate down-move extends by a further 1/3.
  

Note: The odds that the limit price will be reached before the stop is hit are probably worse than even, but the potential recovered-profit to potential additional-loss ratio is two-to-one. This makes it the rational decision to take provided that the additional loss would not be excessive: hence the necessity to cut back immediately if the position being carried is unusually large (the basic rules on the determination of position-sizing are discussed below).

1b - 2) as evidenced by a sudden volatility expansion, with the trend:

A sudden acceleration of the existing trend with greatly expanded single-period range. This type of action may also (but will not neccessarily) follow-through with a succession of similar periods. This is usually the final bull-market buying-panic during the course of which the "last fool" finally gets into the market. This type of move can provide spectacular profits to those who stay with it but frequently reverses as brutally as it proceeds. Generally referred to as a "blow-off or "spike" top (or bottom if the chart is reversed).

Trading rules:

• If carrying a position against the trend: Get out immediately. It is very occasionally appropriate to panic. this is one of those times. For survival it is very important to be amongst the first (not last) so to do.

• carrying a position in line with the trend: place an "exit-stop" just below the start of the acceleration (above if the move is down), and follow the move up with a trailing stop (see below). You may be stopped-out well before the final top: but that is much better than watching a massive profit wiped-out by staying with the move to the top, and then staying with the following collapse. There is absolutely no way to judge in advance where a "mass hysteria" move will end. When people start confidently to predict that a price which has already tripled is going to re-double might be a good time to sell.

• If not already carrying a position: Stand-aside (watch and weep).