The
Volatility Breakout technique is a bold but potentially very profitable one. It exploits a phenomenon that is not at all rare but (and there can be no doubt about this) very difficult to intercept. So is it only the purview of experts? Not exactly. With a bit of experience, and an in-depth knowledge of the tools to use, the Volatility Breakout technique can be taken into consideration
even by non-professionals.
In the following article, we will talk about the Volatility Breakout technique, listing its pros and cons, opportunities and risks. Finally, we will give space to a very useful tool for handling this complex but interesting technique.
What is Volatility Breakout
As the name quite didactically suggests, the Volatility Breakout technique exploits
breakouts caused by volatility. An occurrence that, as already mentioned, happens not infrequently. An occurrence that, it is worth specifying, is caused not only by external factors, such as the release of unexpected news (which by definition cannot be predicted) but by a technical issue, by the dynamics of trading.
The phenomenon in question is the sudden trend reversal, lasting a few sessions and capable of producing a large pip differential. It is precisely this differential that determines the excellent profit prospects that characterize Volatility Breakout.
The
standard dynamics involve a fairly solid trend, the appearance of an unexpected rebound, and then a trend reversal lasting a few sessions. As already mentioned, it can happen due to factors that can only be intercepted by fundamental analysis, but also by the dynamics of trading. Volume, however, rarely plays a leading role. The reversal is rarely preceded, at least in the case of Volatility Breakout, by volume changes. On the contrary, such changes are signaled (and even massively) once the reversal has already occurred. After all, it is precisely the high volumes that cause such a large pip differential.
The advantage of Volatility Breakout
The Volatility Breakout technique is potentially effective. Indeed, so effective that it can be codified into a trading system. Of course, such codification determines a certain rigidity, but it is also a symptom of effectiveness. In any case, there are at least three reasons why the Volatility Breakout technique can be effective.
When a breakout generated by volatility occurs, the pip differential is generally high. Trend reversal is always an event capable of moving and activating investors. In general, where liquidity and participation increase, pip differentials increase (obviously in one direction or the other). This is undoubtedly a point in favor of the technique, which for this reason can be considered potentially profitable.
It does not require a long study on technical analysis. The breakout generated by volatility is a sudden phenomenon. Before it occurs, it gives some signals but
not so many signals. This means that the technical analysis actions to be implemented are limited in time. This, of course, does not mean that technical analysis is simpler, far from it. It simply has a more limited time horizon.
The phenomenon is not rare. It is worth repeating. Unlike many other techniques, Volatility Breakout is not based on rare events. Breakout ex volatility, to use an elegant expression, happens, certainly not often but with a frequency that cannot be ignored. It's just that most trading systems, given their
apparent unpredictability, tend not to take them into consideration and treat the underlying phenomenon as a period of volatility to be ignored.
The flaw of Volatility Breakout
Obviously, the matter is not all roses and sunshine. First of all, because it is still a technique based on breakout and, as such, dangerous. Sensing the trend reversal means, in a sense,
going against the trend. Therefore, if trend following is considered an approach based on extreme caution, it is clear that Volatility Breakout is not at all.
Secondly, the Volatility Breakout technique can lead to distortions if put into a system, i.e., if transformed into a trading system. Normally, transforming a technique or a set of techniques into a trading system confers security, risk containment, and scientific nature to the investment activity. In this case, however, it can produce frustration.
The reason for this is quite intuitive. The phenomenon of breakout caused by volatility is not rare, it is true, but it is not frequent either. If it is placed as the founding element of the system, the risk is that of
not registering signals. Consequently, the operation is very low and trading becomes more sporadic.
The corollary of this dynamic has repercussions from an economic point of view. While trading remains idle waiting for signals to be generated, the opportunities dictated by a trend following approach flow by. Hence the frustration and, above all, the objective loss of opportunities and therefore money.
How to optimize Volatility Breakout
In practice, how is the Volatility Breakout technique implemented? The issue is more complex than one might expect, also because there is a "sudden" trend reversal to be predicted. One of the safest methods, or rather it returns a lower margin of error than the others, sees
graphical analysis as the protagonist, with explicit reference to certain patterns.
In short, some patterns, and only those, are able to signal with a sufficiently narrow margin of approximation a breakout and the consequent trend reversal which, it is worth remembering, is limited in time and generally does not exceed four or five sessions.
The patterns in question belong to the engulfing line family. The two variants at play are:
- The bearish engulfing pattern, which is activated during a bearish trend.
- The bullish engulfing pattern, which is activated during a bullish trend.
In the first case, we have a white (or green) candle with a small body, followed by a red (or black) candle with a much more accentuated body, and also characterized by a large range between high and low.
In the second case, obviously, we record equal and opposite elements. It starts with a black (or red) candle with a small body, which is followed by a white (or green) candle with a very large body and very distant high/low values.
