### Volatility trading

by Shaun Overton

The forex marketplace supports a diverse community of successful independent traders who have developed winning strategies that work during changing market conditions. Trend-following strategies are popular among newbies, but veteran traders truly earn their keep during times of volatility.

This article gathers and summarizes some longtime traders’ forex volatility trading strategies that can win even when markets are volatile. In fact, the strategies in the volatility trading playbook work best during times when the gains from trend-following systems lag far behind.

## Forex volatility trading

By definition, volatility means that prices rise and fall quickly, and do not show clear direction or trend. Successful volatility-focused trading systems usually feature these characteristics:

• Based on volatility or breakouts from channels or ranges

• Trades are short-term

• Trading systems are very choosy with trades, and are usually out of the market

• Win a high percentage of trades

• Earn only a small-to-modest profit per trade

• Take advantage of small moves instead of big moves

Well-designed mechanical trading systems can anticipate and take advantage of changes in volatility, then exit the trades without giving back the open profits.

## Parabolic stop-and-reverse trading strategy

Some forex traders harness the power of volatility by trading parabolic time-price systems. First introduced by the legendary trader J. Welles Wilder, Jr., the parabolic stop-and-reverse trading strategies capitalize on price reversals.

Parabolic indicators help determine the direction of a currency pair’s price movement as well as indicating when the trend is likely to change and a price reversal is imminent.

These indicators work well for determining both entry and exit points in volatile currency markets, since prices tend to stay within parabolic curves during trends. When prices move wildly, parabolic indicators can help show the direction or change in trend.

Successful parabolic stop-and-reverse strategies are also time-focused: The mechanical trading system weighs the potential gains against the amount of time the position must be held in order to have the best chance of achieving those gains.

If using a “pure” parabolic trading system, the forex trader would always be in a given market, either long or short. For example, when the parabolic indicator generates a buy signal, the trade is entered. Then, when the trend begins to reverse, the “long” position is closed and a new “short” is opened at the same time.

Still, order to reduce the number of quick shake-outs from volatility whipsaws, most parabolic traders filter their trading signals by using a trading volume screen as well as a variety of other indicators.

## Parabolic trading rules

The basic parabolic trading rules are simple – For long signals, the mechanical trading system buys when the currency pair’s price reaches a parabolic point above the current market price, and the trading volume is higher than the five-bar simple moving average trading volume.

In order for a trading signal to be confirmed for this parabolic trading strategy, both parameters must be true during the same time-bar. Here are the general parabolic setup, entry and exit rules used by several successful forex traders:

• Calculate the parabolic points

• Calculate the 5-bar simple moving average (5 SMA) of trading volume

• For long entries, the system buys when the price reaches a parabolic point higher than the current market price, as long as the volume is higher than the 5-bar moving average

• For short entries, the system sells short when a price touches the low parabolic point below current market prices, as long as the trading volume is greater than the 5-bar moving average

• To exit from a long trade, the system liquidates the position when the parabolic points decline

• To exit from a short trade, the system covers the position when the parabolic points rise

• To set the trailing stop for a long position, the system uses the parabolic points below the current market price

• To set a trailing stop for a short trade, the system uses parabolic points above current market price

• Savvy traders often set profit targets like this, for example: 70 pips for GBP/USD or 60 pips for EUR/USD when trading a 4-hour time frame; or, 200 pips for EUR/USD or 250 pips for GBP/USD when trading a daily time frame

## Volatility channel breakout strategy

Many successful forex traders use channel-breakout strategies fueled by volatility. Here are the basic indicators and trading rules for a simple channel-breakout strategy that works for especially-volatile currency pairs on time frames of 15 minutes or higher:

• 30 ATR (the Average True Range over 30 time periods) with 5 EMA (the Exponential Moving Average over 5 periods)

• 15 ATR with 5 EMA

• 30 EMA (Exponential Moving Average over 30 periods) High

• 30 EMA Low

• For long entries, the system buys when the price closes above the upper EMA band and the 30 ATR is greater than the 5 EMA

• For short entries, the system sells short when the price closes below the lower EMA band and the 30 ATR is greater than the 5 EMA

• The trading system sets the stop-loss on the lower EMA band for long positions, and on the upper EMA band for short positions

• With fine-tuning, the strategy may achieve fairly aggressive profit targets

## Volatility double channel breakout strategy

Other forex traders who specialize in harvesting gains from especially-volatile currency prices use a similar, yet “double” channel breakout strategy. Below are the basic trading indicators and rules for a double channel-breakout strategy that works well for volatile currency pairs:

• 11 Relative Strength Index (RSI) at levels 35 and 65

• 20 EMA High

• 20 EMA Low

• 5 EMA High

• 5 EMA Low

• The mechanical trading system buys when the 5 EMA High is greater than the 20 EMA High and the 11 RSI is greater than 65

• The system sells short when the 5 EMA High is less than the 20 EMA High and the 11 RSI is less than 35

• If the initial setup bar’s trading range is more than double the value of the previous bar, the trading system declines the trade

• The trading system sets the stop-loss at the lower band of the 5 EMA for long trades, and at the upper band of the 5 EMA for short positions

• Aggressive profit targets can be set

## Forex trading strategy for extreme volatility

Forex traders who thrive on volatility, there are many profitable trading opportunities. Below is a simple forex volatility trading strategy.

When a long candle appears during a trading session, that is, when an intraday time-bar has a greater range than the previous time-bar, it may be the setup for a trade. Long candles are a sign that volatility has increased, and that a change in trend may be imminent.

Often, after a big candle a new trend may develop, or the previous trend may become stronger. And, the trend will usually be moving in the same direction as the price movement of the time-bar when the long candle happened.

When a long candle occurs, if that candle breaks the high or low of the trading session then the price will probably continue to move in the same direction.

## Trading rules for extreme volatility strategy

• A candle or intraday time-bar which is much bigger than any previous candles during the session, but has not yet reached 100 pips in total range

• That same long candle is also now setting a new intraday high

• For long entries, the trading system buys at 1 pip over the high of the previous candle’s price

• For short entries, the system sells short at 1 pip under the low of the previous candle’s price

• For longs, the stop-loss is set at 1 pip below the low of the entry candle

• For shorts, the stop-loss is set 1 pip above the high of the entry candle

• Profit targets are set according to nearby support and resistance levels

• It’s important to note that any entry order should be placed only after the time-bar containing the long candle is completed, and the trader should use at least one other indicator to confirm the signal before entering a trade

## ATR channel breakout strategy

Some forex traders who specialize in volatility-focused strategies rely on indicators which use Average True Range (ATR).

The trading system determines the midpoint of the ATR channel by calculating the Exponential Moving Average (EMA) of the time-bars’ closing prices, using a number of time-periods as defined by the “close average periods” parameter. When volatility pushes the currency price out of this channel, the breakouts are easy to trade.

This volatility trading strategy is similar to a Bollinger band breakout strategy, except that it relies on ATR instead of standard deviation as a measure of volatility to define the width of the bands or channels. The trading rules for this type of volatility strategy are simple.

• ATR for 20 time-bars

• EMA of the closing prices of each time-bar

• For long entries, when the last price of a time-bar crosses over the mid-band of the ATR channel the trading system buys on the open of the next time-bar

• For short entries, when the last price of a time period crosses the mid-band of the ATR channel the system sells short on the open of the next time-bar

• Stop-loss orders are set 2 pips below or above the first band of the ATR channel

• The trading system sets profit targets according to nearby support-resistance levels

## ATR channel breakout strategy using fractals

Forex traders also use fractal indicators with volatility trading. Below is a simple strategy relying on ATR channels to signal breakouts, and using fractals to determine optimal entry and exit points.

• 130 ATR

• 9 EMA

• When ATR is greater than the 130-period average and the EMA is greater than the 9-period average, trading signals can be confirmed

• When ATR is less than 130 and/or EMA is less than the 9-period average, no trade

• Fractal indicators to show the likely breakout range

• Entry orders are set 1 pip above or below the breakout range

• Enter long when ATR is greater than 130 and greater than the 9 EMA, and fractals confirm the upward breakout

• Enter short when the ATR is greater than 130 and greater than the 9 EMA, and fractal indicators confirm the downward breakout

• Stop-loss orders are set to be triggered if/when the currency pair’s price touches the opposite side of the range

• The trading system closes the position automatically when the volatility decreases, for example, if the ATR goes below 14 EMA

• Set profit targets at a ratio of about 1:3 according to the stop-loss levels; so, for example, if the stop-losses are 30 pips, then the profit target is set at 40 pips

## Volatility meters

Forex traders sometimes use “volatility meters” such as the Volameter indicator for intraday trading signals. These volatility indicators spotlight overbought and oversold zones. The trading rules vary depending upon the indicator. Below are the basic setup and rules that some traders use with the Volameter, a popular volatility meter.

• Overbought/oversold indicator

• Volameter

• Pivot-point indicators

## Trading rules

• A long trade is signaled when the value of the overbought/oversold zone indicator touches or breaks through a level of -8

• Enter the long trade when the overbought/oversold indicator reaches a level of -4 by placing an order to buy-on-open at the next time-bar

• A short trade is signaled when the overbought/oversold indicator reaches a level of 8

• Enter the short trade when the overbought/oversold indicator touches or breaks through the level of 4 by placing an order to sell-on-open at the next time-bar

• Set stop-loss orders to be triggered at 1 pip above or below the price indicated when the overbought/oversold indicator reaches a level of -8 or 8, depending on whether the trade is long or short

• Set profit targets according to nearby support/resistance levels and pivot points

## Volatility creates plenty of forex trading opportunities

There are plenty of good volatility trading strategies in the forex playbook. Traders should welcome volatility because of the profitable opportunities available during trading sessions which feature big price ranges. With appropriate risk management, volatility is a forex trader’s best friend.

Is volatility a friend or enemy of your current trading system?