In this lesson, we will be discussing how to go about using candlestick patterns during volatility contraction.
So, what is volatility contraction?
Here’s the thing…
The market moves from a period of low volatility to high volatility and vice versa.
If you don’t believe me just look at your charts…
Notice that the range of the market, the volatility is never constant!
It always breaks out and you have huge volatility.
And then the volatility kind of dies out, it gets a little slow, candle starts to contract and then it breaks out once again.
This is typically how the market cycle moves, from a period of low volatility to high volatility.
When you are trading, ideally, you want to be entering during a period of low-volatility.
Why is that?
Your stop loss is usually tighter during a period of low volatility.
If you think about it, it makes sense.
Because as the volatility contracts the range gets smaller.
Let me explain further…
How trading low volatility periods can benefit your capital
When the market is at a low volatility period…
You can easily reference the range to set your stop loss.
You would want to use a tool like the average true range indicator to set your stop loss.
The ATR value tends to be relatively low during low volatility period!
So, the benefit of having a tighter stop loss is that you can put on a large position size and still keep your risk constant.
Does it make sense?
A smaller stop loss allows you to increase your position size and still keep your risk constant.
Let’s say you’re risking let’s say $100.
If your risk per trade is always $100, then it’s simply a function of your stop loss and your position size.
If you have a tighter stop-loss, you can put on a large position size, and still keep your risk constant.
However, if your stop loss is larger, then your position size must be reduced to keep your risk constant at $100.
Another benefit to this is that when you enter your trade with a larger position size, it gives you a more favorable risk to reward!
Why is that?
Because you know that the market moves from a period of low volatility to high volatility.
If the market goes in your favor, and volatility expands, you can see that your R multiple on the trade can really rack up pretty quickly.
With that said, let me share with you a couple of examples of trading volatility contraction.
This one over here is the sugar futures:
And again, I’m just going to share with you generally what’s going on in this chart.
The trend is towards the downside.
And you can see that this market traded lower.
Came into the swing low or area of support at 17.97
And then volatility contracted!
How do I know that?
Well just look at the range of the candle.
It got smaller and smaller until it finally broke down.
All you need to do is compare the size of the range of the candle.
If it’s getting smaller it’s telling you that volatility has contracted.
And chances are when it breaks out, it will tend to expand again.
With that said, I just want to share with you a few pointers when you are looking to trade this type of breakouts.
Number one, have the trending move, trade in the favor of the direction of the trending move.
What is a trending move?
A trending move is basically the stronger leg of a trend line.
And the second thing, the volatility contraction, the VC.
You want to see those small candles.
Because you know, when it does break up you can expect the volatility to expand and pick up.
These are a couple of things to take note off.
You can see a strong trending move.
Then when you find a volatility contraction, you get somewhat like a descending triangle.
Volatility expands when it broke down and then volatility contracted again!
You can see that this phenomenon pretty much happens all the time in different markets.
So how you want to go about trading it?
For me, personally, I like to look at the breakout from its low volatility range.
And stop loss is just usually referencing from the swing high or swing low.
For example, if price breaks down on the low, I’ll set it on 1x the Average True Range above the high of the pullback.
So this I know generally how I go about trading volatility contraction.
As I’ve said, I think this is a clear example that this isn’t a trading strategy by itself.
Candlestick patterns are useful to serve as an entry trigger.
But when it comes to stop loss or to trade management and risk management.
You can see that candlestick patterns are not able to go help you answer or manage all these scenarios.
I hope I’ve shed some light on how to go about trading candlestick patterns using volatility contraction.
With that, let’s do a quick recap…
The market moves from a period of low volatility to high volatility. You can see that the word volatility.
You want to enter your trades during a low-volatility period. Because you know it gives you a favorable risk-to-reward on your trades, and your stop-loss tend to be tighter.