Volatility Breakout Strategy in Forex and other CFD Trading
In accomplishing and maintaining success in trading, it is very important to own a rules-based trading method. Many new traders incorrectly believe that market professionals simply follow the market and act on impulse. However, any seasoned market professional will tell you that having a system or strategy is that the bedrock of trading success.
Creating a system means identifying a setup that you simply use and developing a set of trading rules around that setup. Accessing the market with a clear strategy in mind affords you a way better probability of being successful in the long run.
However, given the wide selection of technical tools and analytical approaches to the market, it may be difficult for new traders to identify a decent strategy or system to use. With this in mind, we’re going to explore one of the more popular and effective trading approaches which is the volatility breakout system. Now, before we get look into the volatility breakout strategy in detail, let’s just ensure we are all on the identical page with some of these terms.
What is Volatility?
First of all, volatility simply refers to the amount of movement in the market. In a very volatile market, you can see a lot of movement. You can easily spot a volatile market straight away by looking at a chart. If you see a lot of big swings and price moves, this is a volatile market. If there is less volatility in the market, it means there is no a lot of big movements. Again, you can spot a non-volatile market quite easily on a chart because the price action will be very still and controlled.
In the chart shown above, you can see periods where price is making big moves, labeled as volatile market periods. At other points, you can see that volatility decreases and price stops making big moves. We typically call these two periods trending (increased volatility) and ranging (decreased volatility).
If you look at any price chart of any instrument or market, you will see that the price goes through periods of high volatility and periods of low volatility. This is correctly what creates the opportunity when carrying out a volatility breakout method.
Volatility Breakout Trading Using Support & Resistance
The intention of the volatility breakout trade is to capture price as volatility increases. So actually, capturing the market as it switches from ranging mode to trending mode. This type of volatility breakout system can be carried out on any timeframe and in all markets. There are various approaches we can use and even some tools and indicators that can help us. Now, will take a look at some different volatility breakout strategies.
In the chart above you can see an example of a basic type of volatility breakout trade. In the bottom left-hand corner, we can see that price is trending higher with plenty of volatility in the market. But, in the middle of the chart, you can see that price settles into ranging as volatility dries up.
Once we see the price pause like this, we can draw in our support and resistance lines, marking the swing high and the corrective low of this market pause. This gives us our range, and then we simply monitor the price action and look for price to Breakout of the range and continue higher.
Volatility Breakout Trading With the Trend
Now, it is important to note that for best results, we only want to take the volatility breakout trade if price breaks above the range. Because price was trending higher before the range started, we know that there is a better chance of us capturing volatility if price breaks out higher, continuing the trend. If price breaks below the range, this would be a counter-trend trade and is not something we would look to trade with this system.
Now, the beauty of this system is that it is very simple and only relies on you drawing in the support and resistance lines to highlight the range. Once the range has been established, you can even set a price order above the range to capture the volatility breakout if you aren’t in front of the charts.
So, in this scenario, we would enter a buy trade as price breaks out above the top of the range and we would place our protective stop just below the low of the range. We would then look to target a minimum of twice our risk, this ensures we achieve a positive risk-reward on the trade.
Volatility Breakout Trading with Indicators
Now, while this system is very simple and straightforward to use, some traders prefer to use a volatility breakout indicator. Technical indicators can be incredibly useful for trading a volatility expansion. One of the most popular indicators to use is the Bollinger Bands indicator.
What Are Bollinger Bands?
The Bollinger Band is a technical indicator used to measure volatility and trend direction. The indicator is comprised of a 20-period moving average (the line in the middle of the bands) and an upper and lower band which mark two standard deviations above and below the average. So, this gives us our bands. The purpose of the indicator is to measure volatility in the market and to identify trends.
So, if the bands are wide, this means that volatility is elevated because the price is making big moves away from its average price. If the bands are contracted, this means that volatility has reduced as the price is not moving too far away from its average.
Also, if the bands are turned higher, this means the market is in an upward trend. If the bands are turned lower this means the market is in a downward trend. Finally, if the bands are basically moving sideways, this means the market has not trending and has settled into a range.
So, if we look at our chart example again but this time with the Bollinger Bands indicator turned on you can see just how useful the indicator can be in helping us capture a volatility expansion. So, to begin with, price is trending higher and we can see the bands are turned higher and are nice and wide, showing there is plenty of volatility in the market.
You can then see that as price paused midway up the move, the bands contract as the market loses volatility and price settles into a range, shown by the sideways bands. However, as price breaks out above the top of the sideways bands the bands then widen once again (showing that volatility has returned) and turn higher once again, showing the bullish trend is continuing.
So, as with our basic volatility breakout strategy, how we would trade this is to place a buy trade as price breaks out above the top of the bands, without sop placed below the low of bands.
How to Manage the Trade
Now, in terms of how we manage this trade. We have two options. The first option is that we can trade this in the same way as our basic volatility breakout trade where we simply look to target twice of our risk. Alternatively, we can look to use the Bollinger Bands indicator to manage the trade.
So, because the center line of the Bollinger Bands is a moving average, we can look to manage this trade in the same way we would as trading with a moving average. We are in a bullish trade and we know that the market is in a bullish trend while above the moving average. So, keep it in consideration, we can look to keep our trade open until the price crosses back below the moving average, indicating our bullish trend is over.
Alternatively, we can take another approach using the Bollinger Bands whereby we keep our trade open until the price touches the lower Bollinger Band. Because of what we know about how the Bollinger Bands work, we know that there is a good chance price will continue to trade higher while the bands are turned higher. Now, if the price comes back moving down and touches the bottom of the Bollinger Bands, this indicates that price is either settling into a new range, and we can take profit and wait for another chance to set a buy trade, or price is potentially reversing and so we want to exit and reassess.
So, if we look at our chart again. You can see our entry point as price breaks out above the top of the Bollinger Bands and you can see our stop loss placed below the low of the Bollinger Bands at entry.
Then, you can see our two exit points. The first is the location at which the price crosses below the center line. The second is the location at which the price touches the lower Bollinger Band.
So, in this example, we can see that if we had kept our trade open until the price touched the lower Bollinger Band, this would have given us slightly more profit on the trade.
Volatility Breakout Trading Using Indicators with Support & Resistance
Now, so far, we have looked at how to use traditional support and resistance to identify trends and ranges in order to capture a volatility breakout. We have also looked at how we can use the Bollinger Bands indicator to capture breakouts in a trend. However, if the market has settled into a range for a long period of time, how do we trade a volatility breakout strategy? So, using the Bollinger Bands and also the support and resistance together help us to create profitable strategies.
In the picture above you can see that price has settled into ranging following a bearish trend. The bands were wider and turned lower into the start of the range indicate that the price was in a bearish trend. However, once the price stays in a range and we mark our support and resistance lines, then we can observe that price fails to break lower. The bands contract further showing that volatility has gone and has turned sideways, showing that the range is getting stronger.
So, in this case, as the range has held for so long, we can guess that a trend reversal is a classical move and as price breaks out above the upper Bollinger Band and above our resistance level, we can do a buy trade, with our stop below the support line.
Day Trading Volatility Breakout Strategies
Up to this point, we have been talking about the volatility breakout strategies on the higher timeframes, the daily charts. However, volatility breakout trading is just as successful on the lower time frames, such as the 15 min chart and below.
Again, when volatility in day trading breakouts we can look into associate indicators with some understanding of trend and range. Support and resistance are to help identify a great volatility breakout trade. As we have already explained how to use the Bollinger Bands indicator, let’s move on and take a look at another wonderful indicator we can use and which is the ADX Indicator.
Using the ADX Indicator
Another useful indicator that we can use when trading a volatility breakout strategy is the ADX indicator. The ADX is an indicator that observes the strength of movements in the market. The indicator line varies within a range of 0 to 100. If the indicator line is below 30, means the market is in a range and volatility is low. As the ADX value goes above 30, means volatility is moving up, and above 50 means volatility is high and the market is trending.
So, we can use the ADX indicator to confirm when there is a change in volatility, and we can then utilize our awareness of trend, ranges, and, support and resistance to trade on volatility breakout strategy.
In the picture above you can see a good example of Day Trading on volatility breakouts. To start with, you can see that price was moving in ranging conditions with very low price action. And can also see that the ADX indicator line was in the lower end of the range, showing lessen volatility. As the price starts to turn lower the market breaks and below the support level, it indicates the start of a trending move.
It can be seen that as the price is moving lower, the ADX indicator tends to move higher showing that volatility is increasing. So, once we identify these conditions to simply enter a sell trade looking to capture the volatility,