Volatility Contraction Pattern Trading Strategy

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Volatility Contraction Pattern (VCP) Trading Strategy

In this article, I am going to discuss the Volatility Contraction Pattern (VCP) Trading Strategy – How to Trade the Volatility Contraction Pattern with Examples. Please read our previous article where we discussed Darvas Box Trading Strategy – Trend Following Trading Strategy with examples.

What is Volatility Contraction Pattern (VCP)?

The market never moves in a straight line, it moves from a period of low volatility to high volatility and vice versa. This is typically how the market cycle moves, from a period of low volatility to high volatility.

How Trading Low Volatility Periods Can Benefit Your Capital?

• This pattern can be traded in intraday as well as swing trading
• Your stop loss is usually tighter during a period of low volatility.
• Risk to reward is more
• Look for a higher low before the breakout. Stop loss will be small. tightness in price from high to low.

CRITERIA OF REACCUMULATION (VCP) IN STAGE 2 UPTREND (THE VOLATILITY CONTRACTION BREAKOUT)

1. The stock must be in a stage 2 uptrend and reach an overbought or oversold region before the pattern formation
2. A period of price consolidation must take place above all key moving average
3. Volume must decline as the pattern progress left to right
4. Look for evidence of smart money activity in the pattern before the breakout
5. Breakout with high volume
6. Different types of volatility contraction pattern

The stock must be in a stage 2 uptrend and reach an overbought or oversold region before the pattern formation

For a stock to create the proper setup for the VCP, there needs to be demand.

• Demand means clean and strong momentum which broke out of stage 1 and become overbought
• The simple rule. buying high and selling higher.

How to Identify Stage 2 Uptrend Stock?

The easiest way to spot a stage 2 uptrend

• Strong impulse moves (looks like overbought) and
• Above all key moving average

As you can see in the above image price is in stage 2 uptrend and consolidation above the key moving average.

Two Types of Stage 1

• Accumulation after fall
• Reaccumulation in stage 2 uptrend after overbought

Stage 1 (accumulation)= after the downtrend price accumulates and breakout and follow-through and in stage 2 uptrend

Stage 1( reaccumulation)= in stage 2 uptrend price become overbought and went consolidation above all key moving average

A period of consolidation must take place (volatility contraction)

What happens during consolidation (the logic of volatility contraction)?

The volatility contractions themselves are a product of supply and demand and represent smart money and retailers’ psychology (greed and fear).

1. the instrument makes a new high become overbought and starts to correct as smart money takes the profit. This retracement, like all other retracements, formed in the market as a result of the smart money taking profits off their trades. When smart money takes its profits off, it causes the market to fall down against the previous move up.
2. This fall down makes most of the FOMO traders who had placed buy trades during the latter portion of the move up close their trades at a loss. Or as it does it traps the FOMO buyers at higher prices. these buyers will start to become fearful and will want to sell at a reasonable price (limit their losses) if the price comes back near to buy entry.
3. As the price moves lower, an increasing number of people start to believe the retracement is in fact a reversal and begin getting sell trades placed to try to capture what they assume is going to be a continued move lower
4. Eventually, the price has fallen to a point where a large number of traders got sell trades open. This is the point where the smart money will come into the market and get more buy trades placed.
5. They (smart money) know that when they place their buy trades it will make the market rise slightly, and that’ll cause the traders who went short to panic and begin closing their trades at a loss, making the price rise further and causing the profits on the buy trades they’ve got placed to fall.
6. This process of placing trades and taking profits repeats itself until it reaches a point where the smart money has been able to take the required amount of profit off their trades and get the necessary number of buy trades placed
7. It comes to a point where so many traders have closed their short trades at a loss, that it’s caused the market to move above the high of the retracement. By the time it’s moved this far, most of the traders who went short during the retracement have closed their trades at a loss.

What to Look for in Price Consolidation?

1. The price must correct through a series of smaller contractions. tightness in price from high to low, Higher low before the breakout
2. Volume decreases ad pattern progress
3. Look for evidence of smart money demand through the base
4. Breakout with volume

The price must correct through a series of smaller contractions.

• Each pullback from high should be lesser than the last pullback, representing the absorption of more weak holders. BETTER IS HIGHER LOW BEFORE BREAKOUT
• Look for between minimum 2 pullbacks from high. MORE IS BETTER. the pullback themselves are a product of supply and demand behavior and represent smart money psychology.

Different types of VCP ARE

• triangle
• range
• tight base/FLAT BASE
• cup and handle
• flag
• Darvas box

For more VOLATILITY CONTRACTION PATTERN check here

Volume Must Decline

• As the volatility contraction pattern progress, the right volume should start to decrease. this indicates that the available supply of the stock is being absorbed and once eliminated the stock can resume its uptrend.
• In many cases, the volume printed around the final days of the volatility contraction pattern will be at or around the lowest seen through the entire base (VCP).

Look for Evidence of Smart Money Demand through the Pattern.

• Green candle follow-through and lack of follow-through of down days. generally seen on the right side of the pattern or end of the pattern means before the breakout. This means no selling pressure from sellers,
• Consecutive volume increases on the upside. Look for a series of days where price and volume increase. This represents an institutional accumulation shakeout. Trapping in base low (downside breakout failure). shakeout days help to eliminate weak holders.
• Higher low before the breakout.

VOLATILITY CONTRACTION Breakout Days

As the force of demand begins to overpower the supply, it becomes clear that bulls are going to win.

• The initial sign is the high-volume bullish clean candle
• A clean close above high /resistance

Why high volume in breakout candles?

• Breakout buyers are jumping on the breakout days themselves.
• At the same time, shorts have the decision to make. Either cover before the loss gets worse, or average up, hoping for a failed breakout.
• These 2 bullish forces create a huge breakout volume

Breakout needs follow-through within 2 candles why?

• As the breakout and follow-through shorts are now in more loss, especially if they were averaged in from the prior candle high. They have only one choice to make. As the short covering comes in, this fuels the bullish character of the stock
• Conservative buyers buy above breakout candle high.
• These 2 bullish forces make a successful breakout

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In the next article, I am going to discuss the Volume Spike Trading Strategy with Real-Time Examples. Here, in this article, I try to explain, the Volatility Contraction Pattern Strategy- How to Trade the Volatility Contraction Pattern with examples. I hope you enjoy this Volatility Contraction Pattern Strategy- How to Trade the Volatility Contraction Pattern article. Please join my Telegram Channel and YouTube Channel as well as my Facebook Group to learn more and clear your doubts. Please watch the following video if you want to learn and understand this concept in a better way.