- 1998: Volume 7, No. 3 International Corner: Implied Volatility Gives Best Clues For Market Tops & Bottoms

Since the launch of my first book, Don't Tell The Professionals, I have constantly worked to improve the reliability and accuracy of my own personal trading signals and indicators.

During 1997 I had a major breakthrough by using futures and option volatility data, as provided by CRB, and subsequently focusing my attention on implied volatility, which proved to be both very simple, and stunningly accurate.

In December 1996, I was looking at an option volatility chart book, in which one recommendation was to sell coffee options. The related implied volatility was trading around 38 percent, equating to six month highs and coffee options being deemed to be overvalued.

Fortunately, I ignored the recommendation and coffee prices soared over the next six months with implied volatility doubling! I could not help thinking about those traders that may have taken this recommendation, and thinking there must be a more effective way to sell options or pick market tops and bottoms.

During this time, I was working with a programmer writing a charting package for my own use. Like most traders, you can never find software that includes all of the indicators you want.

A critical feature was to lay implied volatility over the futures prices. What I saw next was stunning-when a market made a significant move it would struggle once the implied volatility had increased by 100 percent or just over.

So, the conclusion is, it's not how overvalued implied volatility is, compared to a set period of six months, one year, or two years, etc., but the percentage increase relative to the underlying market. All of the three charts on the right demonstrate this extraordinary indicator.

Figure 1

Figure 2

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Keith Cotterill is a registered CTA and lives in the U.K. He is the technician driving the trading strategy publications, training course and software products marketed by Trading Edge World Wide Ltd. Since June 1997 well over 1000 subscribers, in the U.K. and U.S., have signed up to Keith's Trading Strategy Course & Software. This article is an extract from Keith's forthcoming book Bigger Than Vegas Better Odds to be released in the fall.

If you would like further information regarding the Trading Edge Strategy Course call: Andy White, 01684-892666, in the U.K. In the U.S. contact Patrick Houlmiere, 1-888-242-7825, e-mail tew@kwca.co.uk

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