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Trading breakouts is one of the most popular ways of making pips from the forex market. Decreased volatility breakout is one of the subsets of breakout trading. While this strategy is similar to the strategy of trading breakouts, but it is specific to a certain conditions in the forex market. Volatility is a measure of the scale of price fluctuations over time. Volatility tends to be high when prices change to a large extent within a short span of time. The reverse also holds when prices oscillate more or less close to a certain price level without deviating much from it over a long span of time.
It is the periods of high volatility that lets traders make pips and it is the volatile nature of the forex market that attracts the risk seekers in search of high returns. However, entering the market in periods of high volatility can be stressful for most of the traders as they dont know whether the trade will go their way or not. Why not concentrate on the low volatility period instead of focusing on the high volatility market. Forex market is just people trying to buy or sell currencies. It is the psychology of the crowd that rules the market in the end. There is a tendency in the currency prices to alternate between periods of high volatility and low volatility in the forex market just like other financial markets. This recurrent pattern is due to the crowd psychology which is the force behind changes in the forex market.
You must understand how trend is developed in the currency market and how the crowd psychology affects the different phases of the trend. There are four main stages of a trend and there is a different crowd psychology behind each stage of the trend. These four stages are:
1) Nascent Trend,
2) Fully Charged Trend,
3) Aging Trend and
4) End of Trend.
These four stages are closely linked to the cycle of volatility in the market. Lets discuss these stages of a trend in detail:
Nascent Trend: Most market players are still skeptical about the possible new trend direction during the nascent stage of the trend. In the beginning when the new trend just starts either upside or downside, volatility is low as both bears and bulls tread carefully and are cautious. Nothing is clear at this nascent stage of the trend when it is forming. Market players are trying to confirm or deny the start of a new trend. So everyone is cautious whether the new trend will continue or it will fizzle out.
Fully Charged Trend: When the trend progresses, it becomes fully charged as there is now evidence from fundamental data that supports the trend direction! It is time for more action now. Traders who are caught on the opposite side of the market become exposed when the new information proves them wrong. A lot of changing positions will take place during this period. Traders who were initially on the wrong side of the market become new converts to the trend. This causes the currency prices to move more dramatically within that stage.
Traders become convinced of the direction of the trend and new information convinces most of the traders of the direction of the trend. Everyone wants to jump in the trend. More and more positions are established. Hence volatility tends to be high during this period. This brings prices to higher highs in an uptrend or lower lows in a down trend.
Aging Trend: This is the third stage of the trend and is the period of consolidation as the trend comes to maturity. As the momentum of the trend exhausts itself, volatility tends to decrease at this stage of the trend. This is the period where lot of profit taking will take place. Experienced traders try to get out of their trades at this stage of the trend by closing their positions. This satisfies the appetites of inexperienced traders as they consolidate their positions. Both the bulls and the bears are hesitant to make daring moves at this stage of the trend. This is the period of consolidation and the prices tend to stay calm during this period. Currency prices have moved by a large amount in the previous period of high volatility. The trend takes a short break and the volatility is low during this stage of the trend.
End of Trend: This is the last stage of the trend and this is the time when the prevailing trend ends and reverses itself after some new information is revealed about a currency that changes the opinion of the crowd. As the market players tend to absorb the information, this results in the rapid adjustment of prices within a short time. Traders become desperate to get out of their positions especially if they have been caught on the wrong side of the market. Many stops will get triggered during this stage of the trend.
The trend now reverses itself. There is a sharp follow through of the prices in the reversed direction during this stage of the trend. Now you understand and know that within a trend, currency prices can experience decreased volatility followed by increased volatility which is again followed by decreased and increased volatility as the crowd psychology keeps on changing.
You must know that sudden release of a breaking economic or geopolitical news can cause a lot of volatility in the forex market. Traders with open positions during this low period of volatility are the most vulnerable to unanticipated news. This volatility continues as long as the news is not absorbed by the market. Decreased volatility can be found during trending or ranging phases.
However deceased volatility provides an excellent opportunity to traders to prepare and profit from an imminent change from low to high volatility. During this time gains can be made from the unsuspecting players and this is known as the Decreased Volatility Breakout Strategy. But the success of this strategy lies in measuring the volatility of the forex market correctly. There are several technical indicators that can help you visualize the volatility in the currency prices. You can use triangle patterns as one of the best indicators of decreasing price volatility in the currency price charts. Combine the triangle patterns with technical indicators to confirm or deny decreasing price volatility. Two of the most useful indicators that can help you measure the volatility of the currency prices are:
1) Moving Averages and
2) Bollinger Bands.
When a particular type of triangle has been identified by the trader, a high probability trade may be in sight. All triangles show decreasing price volatility in the forex market. You can take advantage of the decreasing price volatility in the forex market through identifying the triangle formations. When you have identified the triangle formation on either the daily or weekly chart, get ready for a breakout. Each triangle type has its own directional bias. When you trade triangle breakouts, ignore any first breakout attempts whether it is to the upside or the downside. There can be three possibilities when you try to trade the decreased volatility breakout strategy.
Possibility No 1: Don’t forget, ignore the first breakout. The second breakout attempt is in the direction expected of the triangle type. In other words, the second breakout attempt is in the upside direction for an ascending triangle and it is in the downside direction for the descending triangle. This breakout could signal either the continuation of the existing trend or the trend reversal.
In case of an ascending triangle, place a stop buy order at least 10 pips above the horizontal resistance level to capture the potential upside breakout. You should make sure each side of the triangle gets touched two times at least. Set profit target according to your time frame. Place a stop loss order 10 pips below the horizontal level of the triangle to protect against false breakout. In case of the descending triangle again make sure the triangle is touched two times before the breakout. Place a stop sell order 10 pips below the horizontal support level to capture the potential downside breakout. Place a stop loss order 10 pips above the horizontal support level.
Possiblity No 2: Again ignore the first breakout attempt. The second breakout attempt is in the opposite direction of the expected triangle type breakout direction. In other words, the second breakout is in the downside in case of an ascending triangle and it is to the upside in case of the descending triangle. Cut the position size to half for this trade in order to reduce risk in case of an ascending triangle since the breakout direction is opposite to the most expected direction. Set stop sell order at least 10 pips below the upward sloping trendline in order to capture the expected downside breakout. Place the stop loss 10 pips below the breakout point. Ignore the first breakout attempt and make sure the triangle is touched at least two times. Place take profit in accordance to your time frame.
Place a stop buy entry order at least 10 pips above the downward sloping trendline in order to capture the potential upside breakout in case of a descending triangle. Set your profit target in accordance with your time frame. Place stop loss 10 pips below the breaking point. Again reduce the position size to half in order to reduce risk.
Possibility No 3: There is an equal possibility of upside as well as the downside breakout in case of symmetrical triangles. Just follow the above guidelines and place stop buy entry order or the stop sell entry order 10 pips above the downward sloping trendline or 10 pips below the upward sloping trendline. Similarly set your stop loss orders. The decreased volatility breakout strategy works better when it is implemented on a daily or weekly chart. Don’t use intraday charts on this strategy.
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