The Volatility Breakout Method

By Andrew Gibbs

www.systemtrade.com

Volatility in a stock-market context is simply another name for price movement. A very big price move is often described as a volatile price move, especially if the price went down. The “volatility breakout” refers to a method of trading, whereby the trader seeks to enter the market just as a volatile move in one direction is getting underway. The ideal scenario for the trader is that the price begins to move in one particular direction and keeps moving in that general direction over a specified period. The volatility trading technique that we are about to show you are designed to capture a short term move of 1-3 days.

The volatility breakout method can be utilized for both stock and futures trading, however to get the best results it often needs to be coupled with another type of trade setup as trading a volatility breakout on its own is often not overly profitable. The great thing about a volatility breakout and trading volatility breakout methods is that it gets traders into the habit of buying into strength and selling into weakness. In fact volatility breakouts form the basis for many publicly available day trading systems, but in my opinion the volatility breakouts are best utilized for swing based systems targeting the 1-3 day trade period.

The 1-3 day holding period is an ideal timeframe for a mechanically traded system. The reason for this is that after slippage and commission there is often not enough money left on the table for the client to profit due to a small average trade size. A swing based system however has a similar trade turnover, allowing a fast compounding of profits and the average trade size is quite large so slippage and commission do not have as much of an impact. The timeframe is also ideal for managing risk and because risk can be measured positions can be leveraged by utilising futures or CFDs. This is because we are only in the market for short periods of time so the volatility of the equity curve is far smoother than buy and hold approaches and the profits, on average are large enough to cover slippage and commission costs.

The volatility breakout method is a core component in almost all of our trading systems. Many of out entries and exits include a volatility breakout component, however it is almost always combined with another type of setup to improve the odds of a profitable trade.

Characteristics of a volatility breakout: As mentioned the volatility breakout method seeks to capture a large range day. This is a day that opens near the low of the day and closes near the high of the day after moving in the same general direction for the entire day. On the other hand a large range day could also open near the high of the day and close near the low of the day in the case of a down day. You will notice that in almost all occasion’s days where the market moves several percent tends to open and close at opposite extremes. In the chart below I have highlighted two examples of a large range up day.

The method for getting on board a large range day is relatively simple.

Entering into a large range day

If we think the market is going to go up we enter the market utilising a stop order above the opening price. For instance assuming we think the market is going to go up and the market opens at for example 1000 points, we could wait for the market to reach 1002, meaning that the market is starting to move up and trade in the required direction and if it reaches 1002 we would buy on stop meaning that if the market trades at 1002 we then buy at market. If the market keeps trading through this number and closes at 1005 points we would have a 3 point profit. The benefit of waiting for the market to begin trading in the required direction is that if the market opens at 1000 and then trades immediately lower we would not buy on that particular day as it didn’t reach our entry target. The benefit is that the market may open the next day at say 994 and we could look to buy at the open+2 points or 996 points and thus we would get in at a lower price with the market starting to move in the required direction.

Long trade entry

The opposite is also true for a short position. If for instance the market opens at 1000 and we are looking for a short trade for the day we could wait for the market to start moving lower and enter our short position if the market reached 998. This type of order is called a sell stop or selling on stop at 998 (open less 2 points). The 2 point move we are waiting for in our required direction is known as an expansion factor.

Short trade entry

In summary what we are seeking to do is to buy (sell) on stop at the opening price plus (or minus) an expansion factor (2 points in the example above).  The expansion factor is the number of points above or below the opening price that we use to calculate out trigger level.

Methods for Calculating the Expansion Factor

The expansion factor is generally described as a percentage of the previous 1-10 day average range. In trading terms the range is described as the high minus the low for the day. For example if the high price on a particular day was $10.10 and the low price was $10.00 the range would be $0.10. Because the range on a particular day varies so much you can choose to use an average range. This involves calculating the high price minus the low price for each of the previous XX number of days (we use 6 or 7) and calculate the average.

S&P 500 Futures Example

The chart shown above is of the S&P 500 and shows the past 9 trading days. To calculate the average range we will use a look back period of 7 days (you can choose any number) and take a percentage of that. The numbers in the column are the open, high, low and close.

The range is simply high minus low. To calculate our expansion factor we work out the high minus the low for each of the last 7 days and divide by 7.  The average range in the example above is 15.2. To calculate our expansion fact we can take any percentage of the above number and use that. For instance 25% of the 7 day range is simply 15.2*0.25 which equal 3.8.

Example 2: Commonwealth Bank of Australia Example

Example: The chart below shows the previous 6 days of price movement in CBA (Commonwealth Bank of Australia) with the data window below.

On the 23rd October the high price was $41.85 and the low price was $41.20 so the range was $0.65. On the 24th October the high price was $42.04 and the low price was $39.59 so the range was $0.45. The range on the 27th was $1.91, on the 28th the range was $0.70, on the 29th the range was $0.94 and finally on the 30th the range was $0.56. If we add all of these together and divide by six we get the average range for the past six days. The average is $0.90.

Using the Expansion Factor

Now that we know what the average range has been for the past XX number of bars we can use this number in a variety of ways. For instance if we were trying to capture a large range day and looking to enter the stock in the direction of the days trend we could buy on the open plus 25% of the average range so if the price opened at 900 and 25% of the average 7 day range was 3.8 points we could buy at 903.8 on stop. The example here is that if the S&P 500 opened at 900 we would have the order in to buy at 903.8 if the market trades at this level i.e. as soon as 903.8 or high trades we enter the trade using a market order.

Note: Do not be too daunted by the formula, a good charting program will produce these numbers for you so you do not need to calculate them by hand each day. In fact all of the information contained in this manual can be programmed into Trade Navigator so you can quickly and easily assess the market each day in a matter of minutes.

This little entry technique is a great mouse-trap, it gets you into the market in the direction of the daily trend and it is also profitable as a strategy on its own.

United States Example Using Futures:

The table below shows a report from trading with a volatility breakout entry on a selection of the most liquid commodities contracts in the US. The table is just from trading long only, however you can see we have a slight positive expectancy across all of the markets in the test. It is through the utilization of a combination of factors that gets a trade working to our advantage.

It’s Profitable on Stocks as Well

Again, to show you the robustness of this technique we are going to look at a non-US market. The market we’ll look at is the Australian sharemarket. The table below shows the results for buying one share of each of the stocks listed in the below, i.e. a selection of the most liquid stock listed on the Australain Stock Exchange. You can see that BHP wins with this technique 56.7% of the time and has a payout ratio of 1.28 (average win/average loss) so it wins more on average than it loses and wins more than 56% of the time. This means that you have the odds in your favour and the beginnings of a profitable strategy. An analysis of the table below also shows that this particular entry technique also works on CBA, CSL, MQG and NCM.

This should give you an idea of how we enter the market by waiting for the short term trend to establish itself first using a method termed a volatility breakout. It is important to understand that you cannot trade this technique on its own, which is why we pre-qualify the market first using a price pattern or seasonal move prior to entering the market.

The advantages of using an expansion factor of the previous range mean our systems adapt to market conditions including current market volatility and price change. Using a fixed amount or fixed percentage just does not take into account the current market volatility. Later on we are going to use volatility to work out our position sizing and you will see that by using this method we put a smaller position on in times of higher volatility and a larger position on in times of low volatility, thus managing risk more effectively.

In our next article we are going to show you the various different methods you can use to calculate a volatility entry and how we utilise the volatility breakout method for calculating stop loss distance, along with how we use volatility based stops to run short term trailing stops.

For more information on our trading systems check out our website at www.systemtrade.com

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