Most traders have heard the story of Long Term Capital Management (LTCM). For those who have not heard the story, LTCM was a hedge fund designed to take advantage of situations where the price volatility of a financial instrument would go from higher than average to normal (the mean). Can lowly traders such as ourselves take advantage of volatility as a warning that large moves are coming? The answer is yes. Most traders would agree that periods of high volatility are usually followed by periods of low volatility. But what about the other way around? Are periods of low volatility followed by periods of high volatility? They are indeed (most of the time). Today, we will briefly discuss a strategy that you can use to take advantage of volatility explosions.

Here is a quantified signal to take advantage of these occurrences. We are going to focus on getting clued in on volatility increases before they occur. Optimized historical tests have shown that it's effective to compare 6-day historically volatility against 100-day historical volatility. When 6-day historical volatility is 50% or less than 100-day volatility, this tells us that the stock or index has calmed down and it becomes likely that a large market move is about to happen. Keep this in mind if you are considering entering a straddle. You can use this technique to find ideal entry points. One extremely effective technique for entry is to find a stock that fits this low volatility criteria. Once the stock breaks out of a tight range (which should be in place based on low volatility), trade the stock in the direction of the breakout. So if the stock plummets downward, then sell short, and if the stocks shoots up, go long. Usually, the longer a stock or market index stays in this low volatility state, the larger the move will be once it breaks out.

You should use stops with this technique in the following way. Once you get a breakout following the period of low volatility, take note of the high of the breakout day if it is a bullish breakout. Once the stock closes above the high of the breakout day, then go long on the stock. Use the low of the breakout day as your stop loss price in order to reduce risk.

Price Headley is the founder and chief analyst of BigTrends.com.