Capital Ideas & Analysis

In Active Trader Magazine there was a trader by the name of Volker Knapp who described a trading system where one would wait for the standard bollinger bands both come within the standard keltner channels. When this happened, he considered it a true volatility squeeze. He would then use a momentum oscillator to take the trade. It builds off of a very simple concept about markets. Simply that they trend, then they consolidate and chop around, then off to then next trend they go.

Its a solid system. Certainly easier to back-test. however, i dont find it the best method. Rather, if we think about the process of price formations, squeezing out volatility is exactly what they do. And just about every time ive seen this volatility squeeze, there is a price formation to follow.

Flags, Triangles, Rectangles, double bottoms, triple tops, rising wedge, cup with handle, there just always seems to be a formation. Linda Raschke pointed out that the ADX line also tends to drop within formations. Which of course makes sense because formations are trend-less.

So we want a market that has bollinger bands squeezed within the keltner channels and a low ADX. below 20 is ideal. AEO was a recent trade i took on this.

Here we have a nice and low ADX line and the bands well within the channel for a long period of time. The -DI and +DI should be in agreement with the break (+DI is rising on breakouts, -DI is rising in breakdowns). On the breakout we see above average volume and a rising CMF. We can also see this as asymmetrical triangle.

how could i take the breakout and not get involved back in January? First, there was no formation. but secondly, and most importantly, price channels.

We look for markets where volatility  and trend is squeezed out. Then we look for a price formation. after that we want to see if we can find a price channel that has not been violated on either side of the formation. Once that is identified, that is the entry levels for breakouts or breakdowns.  In addition to the volume data, you want to see breakouts to the upside register overbought on short term oscillators. if it isnt overbought, dont do a damn thing! if it isnt oversold, dont you dare short it. You should also have longer term momentum (MACD) pointing in your favor. Lastly, the day of the breakout should not be reversed within the next three trading days. Thus a conservative stop-loss should be placed slightly below the breakout days low (or breakdown days high).

You exit by the initial protective stop, the price target of the formation, or a trailing channel stop. For this, i have been using the channel found within the formation, dividing by 3. so in this case, a 43 day channel formation requires a 14 day channel trailing stop.

This works on all timeframes. the 1995 breakout in all markets was preceded by a monthly volatility squeeze. The original article was intended for 60 min price bars. It also works on all markets

Here is gold on a weekly chart breaking out of a triangle in 2007. a move i caught off the formation alone but without this extra assistance.

Procter and Gamble (PG) breaking down in early 2009 on the daily.

10yr bonds breaking out in the past month as well as in November 2008

$USD breaking higher in july 2008, lower in dec 2008, lower in mar 2009

Entry: band squeeze, low ADX, price pattern breakout in addition to a channel breakout. Indicators should be overbought for longs, oversold for shorts. Volume and longer term momentum should be favoring the move.

risk management: initial protective stop at the opposite side of the breakout day. One could also sell options at the formations price target to lower risk and increase potential gains.

Exit: protective stop, trailing channel stop, or at the formation price target.

This works on all time-frames and all markets for very simple reasons. it takes a basic concept about markets, that of which is that they trend then consolidate until traders decide to continue or reverse the trend.  Then asks traders to do the most difficult thing in the world; buy breakouts and sell breakdowns. to embrace “overboughtness” as a long signal, and then to hold on for dear life.