13.4 A Complete Volatility-Based Trading Strategy

Additional Reading About a Complete Volatility Based Trading Strategy

A Volatility-Based Trading Strategy - Text Version

In the previous lessons, we have explained what volatility is, how to measure volatility, how to forecast future volatility from current and historical volatility, and the most popular indicators used for measuring volatility. In this lesson, we will present a complete trading strategy you can use to trade Forex which uses volatility to partially determine trade entries, and fully determine trade management and trade exits.

This strategy is built for a daily time frame, because most people work and only have a small amount of time to trade. You can make money, though, over the long run, even if you spend just a few minutes per day trading. You just need patience and discipline.

This strategy works best with currency pairs from divergent economies, such as the Euro-Dollar and Dollar-Yen currency pairs, but it also helps to be diversified among many U.S. Dollar currency pairs.

The entry rules are as follows for long trade entries. Just reverse the rules for short trade entries.

Wait for a candlestick to close at the highest close of the last twenty days. You can spot this with your eyes and at the end of a day; there is no big hurry. Then, applying the twenty-day average true range indicator to your chart or trading platform, check that the entire range of the candlestick, from top to bottom, is bigger than the range shown in the average true range indicator. This ensures that an entry happens only when volatility is relatively high. Finally, check that the close of the candlestick is within the highest quarter of the candlestick. This ensures that there is strong momentum in the direction of the trade. If these three criteria are satisfied, you can open a trade.

Your trade should always have a stop loss based upon the current value of the average true range indicator. Anything between 25% of that value to 300% should work. What matters most is that you use the same value consistently. The smaller the value, the more profit you are likely to make over the long-term, but it will also lead to a higher amount of losing trades. It is truly up to you, based upon your own psychology, tolerance for losses, and patience.

At the end of each day until the trade has hit the stop loss, check whether a new higher price has been made. If it has, then move up the stop loss so it equals the highest high minus the average true range value, multiplied by the multiple you are using. You should only ever move a stop loss higher, and never lower.

One final rule: never have more than one trade open in the same currency pair. Although it might be profitable, if you do this, you risk heavy losses to your account if there is a sudden large market movement against your position, like the Swiss Franc’s sudden, massive gain in 2015.

The last thing to consider is how much you should risk per trade. It should always be a percentage of the equity value of your trading account and it must be the same on every trade. A value of between a quarter and a half of one per cent is probably most appropriate. If you are using a small stop loss, it is better to use the lower end of that value range.

We end with a warning – although this strategy is highly likely to be profitable based upon hundreds of years of market behavior, most of the trades will be losers, while a few will be huge winners. Trading this strategy requires patience and discipline.

That’s it! This is a complete volatility-based trading strategy. We hope you have enjoyed the course and gained a greater appreciation of how much an awareness of volatility can improve the profitability of your trading.