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Oct. 22, 2014, 11:23 a.m. EDT

Using volatility and Fed data to call the next trend

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About Alexander Elder & Kerry Lovvorn

Dr. Alexander Elder is a private trader and a teacher of traders, based in New York City. He is the author of several international best-sellers, including "Trading for a Living" (1996) and "Come into My Trading Room" (Barron’s 2002 Book of the Year). Dr. Elder runs world-famous Traders’ Camps and is the founder of SpikeTrade.com, a Web site for traders.

Kerry Lovvorn is a trader and a trading coach, whose work has been featured in several books. He teaches advanced trading classes and is a co-author of an e-book "The New High – New Low Index." Kerry is a co-director of SpikeTrade.com, responsible for the nightly market analysis and a trading plan for the following day.

Together, Dr. Alexander Elder and Kerry Lovvorn run SpikeTrade – a unique club where serious traders compete for prizes and share ideas. They can be reached at info@SpikeTrade.com.

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By Dr. Alexander Elder and Kerry Lovvorn

We all are familiar with the term quantitative easing (QE). It is an unconventional monetary policy of stimulating the economy by massive injections of liquidity. The U.S. Federal Reserve, followed by other countries' central banks, began it in December 2008 to help stimulate the economy after the colossal financial collapse earlier in 2008.

For a larger chart, please click here .

The monthly chart of monthly chart of the S&P 500 shows the sequence of QE events. The Fed announced the first QE in December 2008, and the S&P 500 formed a low in March 2009. The bull market persisted, interrupted by two reactions in 2010 and 2011. After the Fed ended QE1 in March 2010, the S&P 500 dropped 17% to a low in July 2010.

QE2 was introduced in October 2010 and ended in June 2011. The S&P 500 had just made a high, and the end of QE2 led to a selloff of 21.5% before a low was formed in October 2011.

The Fed introduced QE3 in September 2012, and it is scheduled to end at the end of this month. A selloff began last month in anticipation of the end of QE3.

The market tends to drop over 15% after QE ends. If the current selloff follows this pattern, the S&P 500 will fall below 1715. Let's add volatility measurements to find what we may expect in the months ahead.

Markets rise on lower volatility and fall on higher volatility. If we think of volatility as anxiety, market participants are much more anxious when the market falls than when it rises.

For a larger chart, please click here .

This weekly chart of the S&P 500 features a Percent ATR indicator. Most software programs give you ATR (Average True Range), and if you divide it by the price, you'll find Percent ATR which measures market's volatility. A 50-point move when the S&P 500 trades at 1,000 is 5% but a 50-point move when the S&P500 trades at 2,000 is only 2.5%.

In the chart above, we see that the market rises when volatility, measured by Percent ATR, remains below 5%, but falls when Percent ATR rises above 5%.

Whenever the Fed ends a QE and volatility rises above 5%, we can expect a correction of over 15%. QE3 is scheduled to end this month. Volatility is nearing the 5% level. If the Fed does end QE3, market participants' anxiety is likely to raise volatility above 5%, pushing the current selloff to lower levels.

If, on the other hand, market participants are not as nervous, Percent ATR will remain below 5%, and the market will be positioned to form a base for the next bullish phase.

Combining QE news with volatility measurements will allow to anticipate which outcome is more likely and trade accordingly. We watch these numbers very closely and update them in SpikeTrade.com whenever they reach or cross important levels .

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