Volatility Contraction Pattern – Definition & How to Profitably Trade it?

Trading Volatility Contraction Pattern is one of the most popular trading strategies. This pattern is among the most reliable patterns for trading and it has proved itself timeless. 

Given the importance of the Volatility Contraction Pattern in trading, we decided to help you understand this pattern in the simplest words. In this article, we are going to explore this unique pattern. We are also going to explain how you can profitably trade it. So, let’s begin right away. 

Volatility Contraction Pattern – definition

The Volatility Contraction Pattern is a pattern that develops during a consolidation period. In simplest words, prices of financial instruments form a contracted pattern when volatility and volume also decrease. This contraction results in a squeeze in price movement. A sudden increase in volume eventually causes a major breakout and prices begin to increase. 

Explanation

Understanding market consolidation is a prerequisite for understanding the Volatility Contraction Pattern. 

Consolidation period 

A consolidation period is a period when trading volume decreases significantly as compared to previous timeframes. In simple words, it is a period of rest when candlesticks become substantially short. During this period, trading decreases, and the market moves sideways. Moreover, consolidation may happen in both uptrends and downtrends. 

If we go into detail, big institutional investors and big traders wait keenly for consolidation periods. They begin to enter the market near the initial support level. Big market players prefer to keep their interests hidden from the market. Therefore, they begin to accumulate near the consolidation period slowly because they don’t want any unwanted attention. Why do big players do this? They do this and keep entering the market with small orders because larger orders spike up stocks immediately. 

Big players never want unwanted attention because they seek to enter at very favorable prices. Given the fact that they cannot enter on a single day, the consolidation period suits them. It enables them to gradually enter the market without attracting too much attention. Additionally, they may also sell a portion of their investment near the initial resistance level to keep consolidation intact. 

That being said, it is important for individual traders to observe what smart money is doing. And for that, the Volatility Contraction Pattern is your best ally.

4 key factors that play a key role in forming the Volatility Contraction Pattern

There are 4 key factors that play a key role in forming the Volatility Contraction Pattern.

1. Strong demand

Strong market demand for a particular instrument is necessary for the Volatility Contraction Pattern formation. That means, it appears during the consolidation period within a strong uptrend. In fact, a number of market players think that the market is overbought and a decline is imminent. However, experts are able to recognize the underlying demand for that security. 

2. Recent selling pressure

Strong demand for an instrument is followed by selling pressure. It isn’t a surprise at all as most traders think that the market is overbought. This is actually a time period that causes a battle between forces of supply and demand. And it is the traders’ job to identify which force has the upper hand. 

3. Supply beginning to decline

After experiencing some overbought correction, the supply begins to diminish. However, it is important to understand whether the instrument finds another support or not and how strong the support is. This is the area that shows extremely tight price action and extremely low volume. Yes, it is the consolidation period we discussed a short while ago. 

4. A strong breakout

Finally, forces of demand overpower supply and a breakout occurs. Given the fact that bears exert their full force, the breakout is often very strong with extremely high volume. 

Volatility Contraction Pattern – Provides you with an edge

Risk management is a prerequisite to success in trading. You cannot even think about trading without properly managing risks. Therefore, it is important to think about risk management whenever considering any trading pattern. And getting an edge over the market is equally important to managing risk. Here comes the Volatility Contraction Pattern into the picture.

As you know, trading is a game of probabilities and all successful traders accept the fact that losses are inevitable. But having an edge means enjoying the lowest risk/reward ratio and higher profits most of the time. And the Volatility Contraction Pattern shines in this aspect. It gives traders the perfect opportunity to make significant gains but the lowest risk. 

Steps to trade Volatility Contraction Pattern 

Now, it is time to understand the steps you need to take before learning about how to trade the Volatility Contraction Pattern. 

1. Identify a big bullish or bearish candle that forms during a strong uptrend. The candle often has a shorter wick.
2. The volume of the candle must be substantially higher than the previous candles. 
3. After the formation of the big candle, at least three candles should form inside the body of the big candle.
4. Now, wait for a strong breakout above the high of the big candle. A high volume must also accompany the increasing price.
5. Enter your position after the confirmation of the breakout. 

How to trade the Volatility Contraction Pattern

The Volatility Contraction Pattern is a highly rewarding pattern when identified and traded accurately. Why so? Because it gives traders an opportunity to trade with high-profit probability but less risk. As you know, the pattern gives traders numerous opportunities to enter trade near a key support level. However, if you want more accurate signals, here are three ways to do it.

1. Using Bollinger Bands

You can use Bollinger Bands for more accurate signals to trade the Volatility Contraction Pattern. Using the indicator, you can enter the trade on a key support area. The best level to enter the trade is near the bottom of the Bollinger Band indicator. 

2. Using Exponential Moving Average 9

You can also trade the Volatility Contraction Pattern using the Exponential Moving Average 9. The best level to enter the trade is EMA 9 pivot coupled with average volume. An increase in buying volume validates a shift in momentum and thus provides confirmation. 

3. Buy after the confirmation of the breakout

This strategy involves being patient and waiting for the confirmation of the breakout. Once the price breaks above a key resistance level, you can pull the trigger. However, it is critical to observe the volume. It must be high or at least it must be above average. 

The wrap-up up

A Volatility Contraction Pattern is a pattern that forms during a consolidation period. In simplest words, prices of financial instruments form a contracted pattern when prices move sideways, volatility declines, and volume also decreases. The main advantage of this pattern is that it significantly helps in risk management. Moreover, this pattern is easy to trade as you have to watch out for the breakout. However, it is better to use indicators like Bollinger Band or Exponential Moving Average 9 for confirmation.