Why Stock Trading Could Get Easier This Year…

2011 was quite a year. Between threats of a second global meltdown, violent price swings in stocks and political incompetence, investors have faced an uphill climb to just to stay at breakeven. Don’t let the financial media fool you with talk of market changes right away — as far as I’m concerned, we’re still in the thick of it.

It’s true that volatility measurements remain well above historic averages. However, the volatile action that has plagued stocks and baffled traders over the past 6 months could subside at some point this year. That means market conditions could become much more favorable to traders. Clearer entry and exit points will materialize when higher periods of volatility subsides — and fewer whipsaws will force traders to cut early losses.

Unless you’ve been living under a rock for the last year, you’ve probably noticed the huge volatility that’s been shoving the stock market in one direction then the other. What you may not have realized is the fact that individual investors aren’t the only ones affected: “…traders who used to profit from price swings are struggling as record stock market volatility shows no signs of abating,” read a recent article in Bloomberg Businessweek.

While the final numbers have yet to roll in, hedge funds are looking to post their second-worst year in history after volatility has knocked around a number of high-profile funds. Victims include John Paulson, who made $5 billion in 2008 by betting against the housing market, and Duke Buchan, whose billion-dollar hedge fund is shutting its doors after coming into the year ahead of stocks by 46% in the last decade. No one has been immune from 2011’s wild ride.

Quite frankly, I haven’t been immune from the volatility either. While my premium trading service’s portfolio booked an average closed gain of 5.39% held over 20.2 days in 2011, that performance number came in well shy of the 19.27% average gain we took home in 2010. While it’s great to beat most investors, it’s still frustrating to trade in this sort of environment.

And it looks like that will remain the case for the time being…

The chart above shows the Bollinger Bandwidth for the S&P 500 — this indicator is a statistical measure of volatility that’s a much less biased measure than popular volatility measures like the VIX. Bandwidth has been inflated lately, rising to a nearly three-year high as recently as mid-September, and remaining above its historical average now. For that reason, it makes sense to expect volatility to remain a factor.

But there is a silver lining to the volatility story we’re seeing right now. You see, market volatility is cyclical — in other words, markets oscillate from periods of high volatility to periods of low volatility.

Looking at the bandwidth chart, it’s clear that volatility has been on the downswing since those September highs.

As a result, I think that we’ll see a return to more normal levels of volatility at some point this year. Although we’ve only seen a handful of trading days in 2012, volatility is already measurably lower. Because of the abrupt drop in volatility, it’s quite possible that a volatility squeeze could pop price action back into swing mode in the near term.

As a trader, you should be watching indicators like Bollinger Bandwidth, not the calendar, to signal calmer waters in 2012. While most high-end charting packages let you apply the indicator, free services like StockCharts.com also enable investors to take a look at the market’s Bollinger Bandwidth with just a few clicks of a mouse.

If volatility does indeed subside in the near future, you should have a much easier time identifying a variety of promising trade setups.