Volatility Breakout Trading Strategy
Mastering the volatility breakout trade
Home » Volatility Breakout Trading Strategy
Volatility Breakouts
What is the volatility breakout trade?
Let’s dig into this tried and tested trading strategy…
Larry Williams is probably the most well-known trader when anyone mentions the volatility breakout system.
But a hat tip has to be given to Welles Wilder, who came up with the average true range concept and indicator as a good way to measure volatility.
The basic concept is that markets move from periods of low volatility to high volatility, and the transition can open up good trading opportunities.
You would identify a period of low volatility and then enter in the direction of the move when you see an expansion in volatility with the assumption that the move will continue in the same direction for a decent period of time.
Note: This is similar to the opening range breakout that Toby Crabel focused so much on. These can work amazingly well in the right conditions. But deploy them in choppy markets and you’ll get faked out all the time…. More on that later.
Larry Williams Volatility Breakout Strategy Rules
- Take the H-L of the prior day (range)
- Add that range to the prior days close to get the ‘up point’
- Subtract that range from the prior days close to get the ‘down point’
Like this:
Grab the range = $1.30
Add and subtract from the close.
A long trade is initiated when the ‘up-point’ is broken and a short when the down point is breached.
A stop loss is placed at the midpoint.
The trade probably needs to be held for several days to really capture a genuine volatility breakout, but you probably could modify the rules for an intraday signal.
eg: 0.25 x the range as a filter
Drawbacks
As mentioned earlier this system is going to get hammered during low volatility. I bet if you took this every day it would have a negative expectancy.
The trick with this and any strategy really is when you deploy it…
So, what might be a good filter to deploy a strategy like this?
Volatility expands after it’s been in a contraction phase, so a narrow range day, week or month could be a good filter to use. See one of those and then deploy these rules on the period after.
A narrowing Bollinger Band width might also work.
Then there’s using Welles Wilder’s tool the ATR as a filter.
When that’s been low for a while and starts to pick up, the market could be entering a volatility expansion phase.
Or you (something I like to do) use it in conjunction with a higher time frame chart pattern.
Say for example the market has been in a flag pattern or range for a while and you want to trade the breakout – this offers a different way than just using the prior high or low as a trigger.
This was just one way of trading a volatility breakout, there are dozens, yet the concept remains the same.
We are trying to capture that shift from small tight range to wider range moves and defining a set of filters and triggers to help capture that shift.
Oddmund over at Quantified Strategies covers a few more here.