“Everything should be made as simple as possible, but not simpler.” – Albert Einstein
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’re going to illustrate this point by looking at Volatility Breakouts, which are a component of our End of Day model.
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.
Volatility breakout strategies are roughly built in the same way: the market moves a certain distance from a previous price level with strong momentum, since momentum tends to precede price. The other principle of price behavior that is being exploited is the alternation between periods of sideways movement (noise) and vertical movement (trend). Price breaking out of a noisy segment prompts us to believe in continuation, which (epending on the timeframe) might only last one day, or several days, or several hours, etc.
The chart above illustrates the “pure” concept: the market gets choppy and reduces directional movement. Volatility contracts, and alerts us (via the narrowing of the Bollinger Bands) that the market is coiling and getting ready to sprint fourth. Our simple indicator Bollinger Band Relative Width is one way of viewing these periods of contraction and preparing for the next breakout.
Same Dynamic, Different Measures
There are only a certain number of ways to identify and measure a volatility contraction. To prove this point we will compare the simple relative width to Donchian Channel Width and the Choppiness Index.
Notice how the periods of contraction (measured using a 20 day rolling period) are practically identical for Relative Width and Channel Width. There is no statistically meaningful difference to be seen here. The similarities become obvious if overlaying Bollinger Bands on the chart.
But some traders might think that choppy markets are something different than “noisy” markets or lateral markets. The Choppiness Index was built in the 1980s to measure how much “noise” there was over the lookback period. As you can see below, High Choppiness periods correspond exactly to low-volatility periods.
Keep it Simple
Using an indicator to systematically identify the period of low volatility has a few key benefits:
- Everything is very clear, so you make less (or no) mistakes.
- You can easily back-test your ideas.
- You can use an algorithm to automatically execute your trades.
The subtleties will arise in the trade management stage, which is beyond the scope of this article. One of the best systematic funds of all time, Dunn Capital, utilizes volatility breakouts on multiple timeframes.
Over to You
In this short article we have highlighted how certain behavioural traits in the market can be identified in many different ways, but all these roads lead to the same result. Hence the need to be very clear about the dynamic being identified (in our case, volatility contractions which preceed breakouts) and selecting the simplest tool possible.
We believe that the Relative Width, along with it’s companion Bollinger Breakout are two tools that fit the bill adequately. With only 2 tools you will be able to spot volatility contractions from a mile away, and also know when the expansion is breaking out beyond the Bollinger Bands.
With some sound trade management and money management, you already have the means to build a robust, time-tested strategy.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals 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.
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