One of the most effective market timing strategies is trading breakouts from tight consolidation ranges. The reason that this methodology works is because markets tend to move from periods of low volatility to periods of high volatility and back again. This is the natural market cycle; it is the way the market breathes.
A market will typically consolidate as accumulation or distribution is taking place, and then quickly move into a markup or markdown phase as the supply and demand imbalance begins to tilt. From my experience, it is much easier to predict volatility shifts then it is to predict actual price movement.
Once you are able to recognize this ongoing phenomenon in the markets, you can position yourself to take advantage of these repeatable occurrences. Keep in mind that the markets are made up of traders, and traders are people who have emotions and feelings. As such, these human emotions leave behind a footprint in the form of patterns that can be seen on the charts by the trained eye.
Today, I will discuss one of my favorite patterns for consolidating trading breakouts in Bitcoin. This trading breakouts strategy combines 3 technical studies – the 89 period SMA, the Bollinger Bands, and the Keltner channel. We will briefly discuss each of these components and then look to combine them to create a solid breakout strategy.
89 Period Simple Moving Average
Moving averages are among the most basic technical indicators available to the trader. Although moving averages are generally not great when it comes to market timing, they can be quite effective when they are utilized for overall trend analysis.
There are many different flavors when it comes to moving averages. Three of the more popular are the volume weighted moving average often referred to as VWAP, the exponential moving average, often referred to as EMA, and the Simple Moving Average, often referred to as SMA.
The VWAP moving average measures the average price weighted by volume. The exponential moving average factors in recent price action more heavily in its calculation. And finally, the simple moving average is an equally weighted moving average. In my research, I have found that the Simple Moving Average works as well as any, so that’s what I typically use.
Next, we should understand the periodicity for the moving average. There is no one best input for the moving average period. And often, traders tend to overthink and over test this parameter which often leads them to an over optimized value that does not work as expected in the real world. From my experience, I have found that the 89 period moving average is quite robust and works well across many cryptocurrency instruments and currency pairs, so that is the one that I typically default to.
The second technical indicator that we will discuss is the Bollinger Bands indicator. The Bollinger Band study was created by John Bollinger, a CTA and money manager. The Bollinger band is very useful in measuring the volatility for a given instrument. Typically, when the market has a good amount of movement, you will see the bands expand. And on the other hand, when the price of an instrument is ranging or consolidating, then the Bollinger bands will begin to contract.
There are three lines that compose the Bollinger Band study. The upper line of the band, the middle line of the band, and the lower line of the band. For the purpose of the strategy that I will be describing shortly, we are only interested in the upper and lower band.
There are two primary inputs for the Bollinger bands – the look back period and the standard deviation. The default setting for the look back is 20 periods, and the default standard deviation setting is 2. I use the customary default of 20 period for the look back but I like to use a 2.25 setting for the standard deviation. I find that this works better than the default setting of 2 when it comes to this particular consolidation breakout method.
If you want to see the Bollinger Bands in action with graph examples, then click here to read about Stellar’s upward movement of 50% for the last week. There, you can see some great examples of the Bollinger Bands and other indicators for Trading Breakouts in action, so that you can further understand how to use Technical Indicators. You can click the link below this article too.
Keltner Channel Bands
The last piece of the puzzle is the Keltner Channel Bands. These bands appear similar to Bollinger Bands, however they are different in one key respect. The Keltner Channel Band uses Average True Range as its parameter for constructing the Upper and Lower bands, while the Bollinger Bands uses the Standard Deviation as its parameter for constructing the Upper and Lower Bands.
More specifically the Keltner channel uses a 20 period Exponential moving average, which is plotted as the middle band. Then a multiplier is applied to the Average True Range indicator or ATR to calculate the upper and lower bands. This multiplier is typically set a 2.
The Bollinger bands are much more reactive to price action than the Keltner channel, and can create sharper lines due to its tracking of volatility. The Keltner bands on the other hand, are less sensitive to price action, and are slower to conform to rapid changes in the market.
While some traders prefer to use one over the other. I like to combine both indicators in a very specific manner. Next, we will take a look at how I do that, and describe my consolidation breakout strategy.
Trading Breakouts: Combining the 3 Indicators
Now that we understand the three different components that will make up our trading breakouts strategy, let’s now combine each into a cohesive method. Firstly, we will use the 89 SMA as our trend filter. Essentially price must be above the 89 SMA to take a long position, and price must be below the 89 SMA to take a short position. Secondly, the Bollinger Band must be contained within the Keltner Channel. When this happens, we can be relatively safe in assuming that the market has contracted and that a breakout opportunity may be emerging.
The actual entry would occur when a candle breaks the recent range and closes beyond it. A stop loss would be placed just beyond the swing created prior to the breakout. Finally, we need an exit plan. For the exit, I like to watch price action and wait until I get some sort of technical signal on the chart which tells me that a reversal may be coming.
Let’s take a look at the image below and see what this looks like on a price chart:
This is a 240 minute chart of the Bitcoin futures contract from May 2 to May 18, 2018. You will notice that the Bollinger bands (green lines) traded within the Keltner channel (blue lines) during the middle part of this time horizon. Around the same time the price crossed below the 89 period SMA. So, with that, the condition for a short breakout trade has been met. Now we have to wait for the trigger. Take note of the breakout candle which closed below the consolidation range. This would be the entry signal.
Soon afterwards, prices began to decline steadily in a stair step fashion. As prices were falling, we were able to draw a bearish trendline which would alert us to a shift in momentum, in case it were to get violated to the upside. You can take note of the last candle on the chart which breaks the trendline to the upside. This was the exit signal that would take us out of the trade in this trading breakouts strategy.
This article is courtesy of Vic Patel, head trader and analyst at Forex Training Group. He is an experienced trader specializing in the Forex and Cryptocurrency markets.
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Disclosures & Disclaimers: FUTURES TRADING IS NOT SUITABLE FOR EVERYONE AND PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS IN FUTURES TRADING OR WITH ANY TRADING SYSTEM OR PROGRAM. CAREFUL EVALUATION OF YOUR PERSONAL FINANCIAL SITUATION MUST BE DONE PRIOR TO DECIDING TO TRADE IN THE FUTURES MARKETS OR ANY GIVEN TRADING SYSTEM OR METHODOLOGY. From: R Quant