If you have been following me on twitter you know I am a huge proponent of the “Volatility Squeeze”, and since my inbox is consistently filled with inquiries about this trading strategy and my use of the Bollinger Bands, I thought I would write a blog post about my favourite setup.
John Bollinger (the creator of Bollinger Bands) puts it, “Bollinger Bands are driven by volatility, and the Squeeze is a pure reflection of that volatility“.
A Volatility Squeeze occurs when the Bollinger Bands narrow indicating that volatility has fallen to low levels while the stock in question enters into a narrow trading range. According to John Bollinger, periods of low volatility are often followed by periods of high volatility.
Bollinger Band default settings are as follows: the upper and lower band are set at two standard deviations above and below the 20-day simple moving average. As volatility contracts the Bollinger Bands squeeze toward the 20-day simple moving average, and as volatility increases the Bollinger Bands expand away from the 20-day simple moving average.
A volatility squeeze candidate is triggered when the Bollinger Band width reaches a six month low. Once you have the ability to recognize a volatility squeeze, you will then have the opportunity to benefit from the soon to follow volatility expansion.
After learning how to recognize the squeeze, the next important step is being able to determine the direction of the breakout. One very important note to be aware of is narrowing bands do not indicate direction, and being able to determine the direction of an expansion is just as important as being able to spot the squeeze.
I like to use the 3 phases of the volatility squeeze:
- The breakout
- Test of the breakout
- Confirmation of the breakout
The breakout signal occurs when the stock price rises at a rate where the Bollinger Bands begin to expand. This is what I call Phase 1 (the breakout). An upside break is bullish, while a downside break is bearish. The breakout is usually so explosive that the lower band will turn downward on an upside break and vice verse on a break to the downside.
Below is an example of a successful volatility squeeze that I was recently able to take advantage of in Intertape Polymer Group, Inc (TSX:ITP):
Default Bollinger Bands set at two standard deviations contain nearly 90% of all price action, this is what allows phase 2 to occur (the test of the breakout).
Usually the phase 1 move is so powerful the price will explode through the top of the upper Bollinger Band, at the peak of this move (which usually last a few days) the price becomes extended, thus allowing for a pull back to test the breakout level (Phase 2). If the test is successful this is where I place my stop, phase 3 then occurs when the price rallies back above the phase 1 high confirming the breakout.
Another condition to be aware of is something John Bollinger calls the Head Fake. It is not uncommon for a stock to change directions immediately after a squeeze, especially if the squeeze occurs at an extended distance from the simple moving averages. This head fake often fools traders into thinking a breakout has occurred only to change course and make a significant move in the opposite direction.
Below is a prime example of a “Head Fake” which recently occurred in the shares of DH Corp. (TSX:DH):
Another question I often get asked is, how do you scan for your setups?
My favourite scan on StockCharts.com: Predefined Scan Results – Move Above Upper Bollinger Band
After performing the scan I store the results in a new ChartList. This is where I then critique each chart, only selecting the stocks with a prime setup to add to my final list.
I really hope you found this post helpful, and with a bit of practice I am sure you will welcome the volatility squeeze to your trading arsenal as I have.
For more on Bollinger Bands I highly recommend the following book written by John Bollinger himself:
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