A trading system is a method to follow when trading the stock market. By method I mean that you have clear instructions about what, when and how to trade. I will show the instructions for the volatility breakout strategy in this article, but the more important part of the system is the “following” part. This is the part where you do whatever the trading system dictates through thick or thin. Why? Because this trading system was built to trade and back-tested for decades to find its strong and week points. The only way for it to behave as expected and display behavior similar to the back-testing period is only if a trader follows it religiously with high discipline. Otherwise, the expected output is unpredictable, since the system you trade is not the same as the one you have back-tested. This is why complete automation solutions are the best way to go (Algo-Trading is the holy grail in trading) when an automated solution is trading A to Z; it is trading the system it was programmed to trade and does not deviate because it’s hungry or tired or started a losing streak. Automation solution keeps you on track 24/7 so you can enjoy the benefits of the trading system that you have.
So let’s discuss the strategy we offer now – the Volatility Breakout strategy.
The Volatility Breakout Strategy
Volatility rules trading – this is because consistency comes from risk management and, for the sake of this article, high risk is high volatility and vice versa, low risk means low volatility.
When observing risk that way, traders, in fact, trade risk and this is the proper way to look at your portfolio – return per unit of risk.
The strategy that I offer here is monitoring equity with low volatility until volatility starts to pick up and the equity triggers a BUY signal for us to enter the trade. This is continued until the volatility calms down and the trade is closed, so it’s a high risk/reward trading system with a re-balancing mechanism for controlling the open position with high volatility.
The system uses ATR and Exponential moving averages (3 of them-5,8,13) to spot low volatility to high volatility move. The three moving averages are used to determine a breakout of a pattern, in case the short term EMA is above the Medium-term EMA and this EMA, in turn, is above the long term EMA we have step 1 of 2 steps to verify entry.
Step 2 is to check ATR(14) and a 5 days SMA signal line over that ATR(14). If both conditions are met it’s a trigger to enter the market; the exit trigger checks the three EMAs only without checking the ATR(14).
Entry Rules
Enter a trade when all three EMAs are stacked on each other and the ATR(14) is above its respective signal line (exceptional volume is a good confirmation at this point)
Exit Rules
Exit the trade when the three EMAs are not stacked anymore, notice that the system does not wait for step 2 of the entry rules.
Re-balance Rules
Re-balancing is used to manage an open position making sure we reduce size when the volatility picks up with an open position, using this formula :
Size = (risk factor X portfolio value) / ATR(14)
Where the risk factor is 0.001 for this strategy, this size calculation during the life of an open position makes sure we maintain the same risk for all open positions in the portfolio.
This is a swing trading style strategy keeping positions open for 3 days to 4 weeks, monitoring it with the rebalance rules until the exit trigger is fired.
Performance
Here is a summary of the strategy performance, the strategy was tested 2013-2018:
| Sharpe | 1.31 |
| Calmar Ratio (MAR) | 0.58 |
| Avg. Monthly Returns | 575.26$ |
| Profit factor | 1.56 |
| Expectancy | 1.19 |
| Net Profit/Loss(CAGR) | 67.78% (9.81%) |
This strategy is a fast-moving system, opening and closing position for a few days and has to be fully monitored.
You may implement the rules in any programming language you wish (our favorite is Python) or SUBSCRIBE NOW and get the entry and the exit triggers in real-time as part of our free subscription plan.
Trade Smartly,
Alon