Stock market volatility has fallen to a six-month low, and an increase in volatility should be expected. As volatility expands, we should learn the direction of the next major trend.

Volatility Contraction Points to a Big Move

Prices ended last week with only a small change. SPDR S&P 500 (NYSE: SPY) lost 0.21% and PowerShares QQQ (NASDAQ: QQQ), an ETF that tracks the 100 largest Nasdaq stocks, fell 0.37%. Volatility declined throughout the week, and now volatility in SPY may be pointing to bigger price moves ahead.

SPY Chart

Market volatility tends to move in cycles from low to high values. Volatility has now fallen to a new six-month low. In the chart above, volatility is shown in the center with the Bollinger Bandwidth. This indicator measures the distance between the Bollinger Bands. Previous six-month lows in this indicator are highlighted by vertical lines. A price move of at least 6% within the next two months followed each of those signals.

Volatility indicators tell us only that a large price move should be expected. Other indicators, like the Bollinger Percent B, can offer clues about the probable direction. In the two examples shown in the chart above, prices moved up after the Bandwidth signal while Percent B was rising. SPY fell when Bandwidth was falling as volatility contracted. These indicators point to a possible decline in prices in the weeks ahead.

ProShares Ultra S&P500 (NYSE: SSO), a leveraged long trade, lost 0.45% last week. I have been bullish on this ETF for the past month, but I think it is time to take profits on this trade. We may see some more upside but the indicators show that there is a high degree of risk in the market now. Leveraged funds can magnify those risks, and closing this trade with a profit of about 6% in a month seems like the safest approach to the market this week.

Recommended Trade Setup:

– Sell SSO at the market price

Gold Sets Up a Short Trade

SPDR Gold Trust (NYSE: GLD) fell 0.62% last week and is now trading at an important support level.

GLD Chart

GLD has fallen to the bottom of a trading range that has contained the price action for more than three months. If GLD moves decisively below $164 and breaks its 200-day moving average, then it could be a short trade. Rather than shorting GLD, I would recommend buying PowerShares DB Gold Short ETN (NYSE: DGZ), an inverse fund that would gain when gold prices fall.

Recommended Trade Setup:

– Place a buy stop order on DGZ at $11.86
– Set stop-loss at $11
– Set price target at $13.15, which would be a new 52-week high

If GLD bounces off support, then the buy signal would be confirmed near the midpoint of the trading range. At that point, the trade would offer a potential gain of about 4% and risk of about the same amount. Until the chart of GLD looks more bullish, long trades seem unlikely to be winners.

This Week’s News

There will be several news releases that offer insight into the economy‘s strength going into the first quarter of 2013. They are expected to be strong enough to keep traders more focused on the fiscal cliff than on the economy for now.

–Michael J. CarrSource: TradingAuthority

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