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The Volatility Squeeze System (Part 1/3)

Nothing is certain in financial trading.
This common market maxim may not be entirely true if we consider the fact that, irrespective of the asset under consideration, prices always tend to alternate between periods of contraction and periods of expansion.
This much we can be sure of.

The Volatility Squeeze System (Part 2/3)

On that note, most traders make the cardinal mistake of thinking that the greater the number of indicators in a system, the better the results.
On the contrary, most successful traders believe in keeping their strategies simple, and instead focus on money management and the psychological aspect of investing.

The Volatility Squeeze System (Part 3/3)

We discuss one such simple, yet highly successful strategy, that makes use of only one simple technical indicator to generate buy and sell signals.

System Requirements

Underlying Asset: Any
Chart Type: Candlestick
Time Frames: Daily, Hourly
Indicator: 20-period Simple Moving Average on the 1-Hour Chart

System Basics (Part 1/2)

Legendary commodities trader Toby Crabel, in his 1990 groundbreaking technical analysis book, “Day Trading with Short Term Price Patterns,” first introduced the concept of narrow range bars.
In particular, he discussed the importance of NR7 as being a leading indicator of major price moves.
NR7 is defined as the narrowest range of the prior 7 bars. So, a candle bar will be classified as being NR7 if its high-low range is the smallest when compared to the previous 7 bars.
An advanced and more powerful version of NR7 is the INR7, which is nothing but an NR7 bar that is also intraday (current period high-low range falls entirely within the prior bar’s high-low range).
To better understand the concept, let’s look at the below chart of EUR/USD, which marks both NR7 and INR7 bars.

System Basics (Part 2/2)

The idea behind the Volatility Squeeze System is to first look at the daily chart of any asset to see if it has just formed an INR7.
In the event that a market has plotted an INR7, we switch to the 1-hour chart and superimpose a 20-period simple moving average (SMA).
Once an INR7 has been spotted, it is safe to assume that the market is experiencing extreme price contraction, and that a break out is imminent. The 20 SMA helps to identify the direction of the break-out.

Entry Rules

1-The first step is to locate an INR7 on the daily chart.
2-We then jump to the hourly chart and go long on the break of the high of the bar that breaks above the 20 SMA. In case the price dips below the 20 SMA, we should wait for it to fall below the low end of the bar that broke through
the 20 SMA, before going short.

Initial Stop-Loss

For a long trade, the initial stop-loss can be placed just below the most recent swing low on the hourly chart. During a short trade, the stop-loss can go above the last swing high on the 1-hour time frame.

Target Price

When the position moves in our favour, the stop-loss can be trailed higher, with the trade being allowed to run until prices reverse below/above the low/high of the prior 5 bars.
Traders can also adopt an Average True Range (ATR)-based trailing stop.

Example of a Long Trade

In the example below, GBP/USD formed an INR7 on March 10th, 2017. We anticipated a breakout, and to confirm the direction, we move to the 1-hour chart and plot a 20 SMA over the price.
The pair first closes above the 20 SMA, and then breaks above the high of that bar (1.2172) on March 13th, 2017 at 02:00 GMT.
We placed our initial stop-loss just below the last major pivot low at 1.2150, and allowed the trade to run until it got successfully trail-stopped out at 1.2221.

Example of a Short Trade

For the short trade, we should look at the daily chart of USD/CHF, which recorded an INR7 on March 8th, 2017.
We then switch to the 1-hour chart and plot a 20 SMA to indicate the direction of the price breakout.
As was expected, the pair closed below the 20 SMA, and a short entry was made on March 9th at 11:00 GMT around 1.0139, which coincided with the low of the bar that crossed the SMA.
The initial stop loss was set above the last swing high at 1.0161, and the trade was trail-stopped out with a small return at 1.0127.

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