Volatility Compression describes a market condition characterized by a significant decrease in the magnitude of price fluctuations for an asset over a specific period. This often indicates a phase of market consolidation or indecision, typically preceding a substantial directional price movement.
Mechanism
This condition is observable through technical indicators, such as Bollinger Bands, where the upper and lower bands narrow considerably around a moving average. This narrowing reflects a reduction in the standard deviation of price, signifying a temporary equilibrium between buying and selling pressures. Trading volume may also decrease during these periods.
Methodology
The methodology involves recognizing these periods of low volatility as precursors to potential breakouts. Traders often position themselves to capitalize on the subsequent expansion of volatility, seeking confirmation from other momentum or volume indicators. This systematic approach leverages the cyclical nature of market volatility to anticipate future price direction.
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