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Main » Articles » Trading Strategy

Volatility Contraction Strategies

The volatility of the price movement is cyclical in its nature. This means that periods of high volatility are followed by periods of lower one and vice versa. This fact makes the volatility more predictable by the price movement itself. After a period of low volatility we can expect a breakout in one direction followed by a trend move. For identifying the set up we will watch for the following short-term patterns:

  • Narrow range 4 (NR4) - this is a period, which range is smaller than the ranges of the previous 3 periods;
  • Narrow range 7 (NR7) - this is a period, which range is smaller than the ranges of the previous 6 periods;
  • Inside bar (IB) - This is a period which high is lower than the previous period high and low is higher then the previous period low;
  • Two consecutive inside bars (2IB) - This pattern consists of 2 consecutive inside bars.

Narrow Range, Inside Bar

Each of these patterns or combinations of them shows that the volatility has contracted and the market is in a period of indecision. This means that a breakout is imminent and we can try to catch the next immediate move. The rules for opening of a position are as follows:

  1. One of the following short-term price patterns is identified on the chart (the time-frame should be determined by tests) - NR4, NR7, IBNR4, IBNR7, 2IB.
  2. We place entry stop orders 2-3 pips above the high (buy) and below the low (sell) of the last period. We can use OCO (One Cancels the Other) orders if it is available on the trading platform.
  3. After on of the orders is executed and we have long or short position we palace stop loss order 2-3 pips above the high (for short position) or below the low (for long position) of the previous bar. We can used fixed stop also, depending on our money and position management rules.
  4. We place limit order according to our money and position management rules.
  5. If the first move is fake we can place new order 2-3 pips above/below the opposite extreme of the last bar and open new position.
Category: Trading Strategy | Added by: forex-market (2009-10-15)
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