Volatility breakout trading is one of the most long lasting and robust trading strategies that the individual trader can use. It is a particularly effective approach to trading some of the forex and futures markets.
What is a volatility breakout? The basic Idea is that if market volatility expands in one direction (as measured from the open) during the trading day, there is a tendency for price to continue moving in that direction for a period of time.
Here is an example of a volatility breakout system: If price moves more than .7 of yesterday’s range above the open, buy the market. The sell rules would be the inverse: If price moves more than .7 of yesterday’s range below today’s open, sell the market. In other words, a volatility breakout strategy is very similar to the opening range breakout strategy. The difference is it defines a breakout by a volatility measurement rather than by time.
For example: Lets say yesterday’s range in Coffee futures was 2.30 (low) to 2.35 (high). The range is equal to high – low, or 5 points. .7 (our multiplier) * 5 = 3.5 points. This means that following this system, today we will be looking to buy long 3.5 points above the open, or sell short 3.5 points below the open.
How to exit? There are a variety of methods that can be used. Some traders look to hold for the full day and exit near the close. Others might look to exit on the close of the second day. Another method is to use a profit target, such as 1to 2 times yesterday’s (the setup day’s) range. As with most all breakout strategies, it is important to use a protective stop as well.
Years ago, I had a day-long job interview on the trading desk of one of the world’s largest commodity hedge funds. One thing I immediately noticed is that one of the most active strategies they used was a simple volatility breakout system traded over a broad range of parameters. In other words, they did not just have one level they purchased in at. Rather, they continued to buy additional contracts as the market moved higher throughout the day.
You need to understand this. The big funds and institutions that drive the market with 100’s or 1000’s of contracts keep buying all day long. By trading with smaller size, the individual trader is in effect able to cut in line and get in front of all this institutional buying or selling. In my opinion, smaller size is one of the greatest advantages that individual traders have!
The real secret sauce to volatility breakout trading is to combine the entry method with additional information. Additional factors like market volatility and price action over the past several days can have a large influence on the profitability of the current day’s volatility breakout signal. In fact, If you are not aware of this additional element of the strategy, it is unlikely that you will find volatility breakout trading to be profitable. Click here to for my free email list.