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.

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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

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 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

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 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

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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)

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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).

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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.

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 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.

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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.

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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

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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).

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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?

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 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

NOTE: FOR MORE ABOUT VCP PATTERN AND interested in MASTER IN VCP
PATTERN, need to read THIS mark minarine’s two trading books,

https://amzn.to/3vGSZJT

https://amzn.to/3QkSKgW

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.

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Dot Net Tutorials
About the Author: Pranaya Rout

Pranaya Rout has published more than 3,000 articles in his 11-year
career. Pranaya Rout has very good experience with Microsoft
Technologies, Including C#, VB, ASP.NET MVC, ASP.NET Web API, EF, EF Core,
ADO.NET, LINQ, SQL Server, MYSQL, Oracle, ASP.NET Core, Cloud Computing,
Microservices, Design Patterns and still learning new technologies.

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