Use LOL to Gauge Volatility

Back in the dark days of no computers (pre-Apple Macintosh), those of us who had a need to know the market's action had to hand-crunch our data. That required both a passion for technical analysis and an ability to spend that study time without giving up the pursuit of the trader's edges. Thus, we had to first think it through and then commit that thinking to pencil, graph paper, and erasers.

I would begin my floor trading days totally focused on, in this order:

• the vols (volatility) and the real value of the options' volatility for that coming day -- as I had to make accurate markets on them, or else!
• how my delta and gamma might swing for each stock in which I made options markets.

Everything else, including thoughts such as "gee, I wonder how the Dow or S&P 500 might do today?!?" was really not that much of a consideration.

During certain periods of any year, options volatility (IV, or the implied/options kind of volatility) in general would begin to recede. Today we can see that in what we know as the VIX and VXX. Back then, all we could "see" and feel as per the vols was what we imagined.

At the worst of the IV (implied volatility) crunching periods, fights would break out over trivial things; most of the time, those things were trades that everybody wanted to participate in but could not, due to the lack of enough contracts to be spread around the pit(s). Traders literally were fighting over proverbial crumbs, when what the needed was food (food being: a serious uptick in the option contracts' volume).

Those times were the genesis of what I call my Coiling pattern, which is a chart pattern where certain moving averages of a stock have coiled into a sort of "knot". That coiling action I would discover, amazingly, coincided with the nadir of the IV, as well as the end of the fisticuffs!

Subtly and slowly, my new pattern began to emerge. It was stealth-like where the intraday IV began to rise, as those intraday stock prices swung from top to bottom and once again during that same day, from bottom to top.

Thus, instead of stocks during a trading day moving in a straight-in-price direction -- which is a trend day pattern, be it up or down -- stocks instead began to swing in price during the day. The more swing days that formed and the fewer trend days that formed, the more the IV began to rise. Me, having to make options markets could sense this change rather quickly, or else!

The indicator that those swing days increasing in frequency created (and they still do) is what I call the "Length of the Line" (LOL). The LOL begins to increase in its measured size as stocks begin to swing intraday from one high to a low and vice versa, sometimes three or more times during any particular day.

As those swing days also increase in frequency, the LOL increases too. That LOL increase is the uber canary singing to those "listening" that the IV for options are today cheaper than they most likely will be by tomorrow.

To further grasp the concept of the LOL, think of a stock beginning the day at, say, $30 and then moving straight up to $31 during the day as that stock never pulls back in price, and doing such with a lack of volatility. The LOL of that stock's move for that day would be 1 point (from $30 to $31).

Now, take another stock beginning that day at $30. Have it open trading at $30.50 (that's a $0.50 linear move). Then have the stock drop back to $30 at, say, around 10 am (that's another $0.50 linear move, the moving total of its LOL equals 1 point so far). Now, have the stock zip back up to $30.90 (that's a $0.90 linear move; the total for its LOL now is $1.90 points).

Then, by, say 2pm, the stock drops back to $30.50 (that is a $0.50 linear move; the total now of the L.O.L. is 2.40 points). By 3pm, the stock bounces up in price once again to $30.90 ($0.40 thus added to total LOL, which is now 2.80). It then closes the day at 4pm at $30.50 ($0.50 added to the running total of 2.80 equals a LOL of 3.30 points for that trading day). That 3.30 totaled is the Length of the Line for that stock for that trading day.

Now, if in prior days to this day in particular the total of each of those prior days' LOL was, say, 1.00, or 1.50, or 0.90, or any other number much less than 3.30, we know that the 3.30 reading for a day, while not a trend, is at the very least a wake-up call that maybe the IV of that stock's options is about to rise.

And if over the next week or two the LOL continues to stay at least 2.0, we would also know that being short that stock's volatility, or having what is called negative gamma, is not wise. Of course, that bias implies that you might want to buy the current "cheap" volatility while it is probably inexpensive.

Of course, what you can do is use my LOL theory, applying it to the major stock market indices. A rising LOL for the S&P 500 has a very high probability to be a precursor for a rise in the VIX/VXX.

Most of the time, rising IV and thus a rising LOL implies lower prices. But that is not 100% fact, as is the case with almost anything regarding the different approaches of technical analysis. For that caveat's proof, merely peruse the S&P 500, comparing its price movement with the VIX from the mid-1990s to the late 1990s. Both the VIX and the S&P 500 increased in tandem for most of that period, much to the despair of those who fought that VIX tape.

Watch the intraday moves of the market. Note their price swings using a one-day chart. See if the highs to lows are increasing in number for a period of days, the length of the line increasing. Then check to see if a stock or major stock market index is coiling! If so, that is a key sign of rising volatility that is highly likely about to soon become a reality.