Recently I’ve helped a few upcoming traders in our System Development Workshop develop their volatility breakout strategies. When building strategies, there is a natural tendency to focus on the entry first and foremost, and almost disregard the fact that setup conditions and trade management are actually more important.
We noted previously that most retail traders tend to overcomplicate things. It seems to be an inherent bias that we are taught somewhere in school or while growing up: the more complex the solution, the better it must be. However, that’s not what the best traders in the world say. All market wizards have promoted simple concepts and subtle application.
Today we will shed some more light on Volatility Breakouts and Volatility Cycles.
Volatility Breakouts 101
The key is to understand the behavioural trait that is being exploited, and start by analyzing the simplest way of exploiting the behaviour. Then, through study and experimentation (or through conversation and dialogue in our Workshop) you will be able to add those subtleties that make a good trading model out of a simple concept.
The essence of a volatility breakout is that if the market moves a certain distance from a previous price level (usually a prior day’s close, high or low), the odds favor some continuation of the move. This continuation might last one day, one week or more, depending on the volatility cycle that you are attempting to identify. But in every case we are dealing with
- a non-discretionary entry level (the breakout level) based on
- a non-discretionary volatility cycle
- a continuation mindset.
The brute excel chart below illustrates short-term breakout levels in blue:
Prior Day Close + X*(Prior Day High – Prior Day Low)
compared to longer-term breakout levels
- 10Day Range = Prior Day Close + Y*(10 Day Range)
- ATR Buy/Sell = Close (T-10) +/- 1.5*22Day ATR
It’s at this point that most traders will start thinking “what is the best to use?”. The reality is that there is no “best fit”! There isn’t even a best variable to use! The only thing that really matters is the volatility cycle you want to capture.
- Do you want to capture 1-Day breakouts (short-term)?
- Do you want to capture intraweek (multi-day, short-term) breakouts?
- Do you want to capture multi-day, medium-term breakouts?
The thing to do is find your preferred way to visually inspect the volatility cycle on your duration. The chart below illustrates tthe different cycles in play with our little exercize.
These cycles are simply the ranges of our volatility breakout channels in pips. But they already show the dynamic in play:
- the 1D channels have more frequent periods of contraction/expansion, but are limited in terms of price movement;
- the 10D channels have less frequent periods of contraction/expansion, but also offer larger payoffs.
- the ATR channel is a much longer-term measurement.
To view things in a slightly different (and perhaps more useful) manner, here are relative volatility measures plotted together. The 6Day and 20Day measures are derived from our Relative Width Indicator. Once again the same dynamic is evident:
- the 6Day Relative Width shows more frequent contraction/expansion cycles;
- the 20Day Relative Width shows less frequent cycles (longer duration of the trades);
- the ATRs are even longer.
And if you’re still not convinced that the volatility channel and relative volatility measures are showing approximately the same dynamic, here is a comparison. Notice that the 6Day relative with and the 3 day range cycle are very similar in nature.
And there is also some similarity between the 10Day Relative ATR and the 10Day breakout channel cycle.
Time Availability, Setup, Trade Management
To sum up all the evidence above: a volatility breakout is simply a range contraction followed by a range expansion. End of story. The entry levels are pre-defined and there is nothing more to be said.
So then, which volatility breakout is right for you? First consider your time availability. If you have less time to monitor and execute potential trades, go for a longer cycle. If you have more time on your hands, consider shorter cycles.
Then work on your setup. Don’t just plot the levels and take every trade. Breakouts work best when the market is coming out of a volatility contraction. So attempt to filter your trades by looking at the volatility condition first.
Also, remember that shorter-term cycles will be more subject to volatility around news announcements, whereas longer term cycles will allow you to disregard all news except perhaps central bank announcements and NFP.
Finally, your trade management will need to complement the duration of the volatility cycle. 1Day cycles will require short-ter management with sub-daily charts; 3Day-6Day cycles will require something a a little longer, etc. It is up to you to analyze the MAE/MFE (perhaps in terms of ATR and not just pips) across various time horizons in order to understand what you can expect.
Over to You
We have spoken about volatility a lot on this blog, and we have discussed volatility contraction strategies here and here. These strategies are quite effective if structured properly. Here is what a system might look like.
- Setup conditions: are we in a volatility contraction? Is there any other consideration (news?) that could impact the trade?
- Buy or Sell on a stop based on yesterday’s close +/- 0.5*(previous day’s range)
- Initial Stop Loss (based on MAE/MFE observations, or zooming into smaller timeframes to find the tightest logical risk placement possible)
- Trade Management (could include a stretch profit target based on MFE + trailing stop)
As you can see, the real investigative work in these systems is in the stop loss and trade management strategies – not in the entry and setup (which are fairly simple to describe).
Whenever possible, simplify your life as a trader.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals and Education from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.