SCOTT WELSH TRADING BLOG

The Volatility Breakout System

The Volatility Breakout System

Mar. 27, 2019

Do you like simple systems?

Everyone tells us to like them, but are they really likable?

For sure, there are advantages to simplicity.

One, they’re mostly immune to the demon called curve-fitting.

Curve-fitting loves it when we filter out and filter out, leaving us with a system that only works on a certain instrument during very specific market conditions.

When we do that, we get great numbers on a market condition that will probably never happen again.

In short, the more complicated we get, the higher the possibility we shoot ourselves in the foot.

On the other hand, if we have a system with only a few simple rules, it becomes very likely the system will work going forward.

“Buying on a dip” will most likely work well now and far into the future.

“Buying on a 13% dip on Tuesdays when the ADX is between 34-36 while the RSI is at 46” is a complex condition that may not work next time and/or won’t occur much in the future (if at all).

So this week, let’s take a look at a simple system.

This system is based on volatility. If price is meandering along calmly, we’re not interested. What we’re looking for is a breakout from a boring range. We’re looking for extreme conditions and trying to ride those extremes to profit.

How do we do it? A very easy way to use this philosophy is to use Bollinger Bands™.

Most of the time, price stays within the bands. Those are the normal times. When price breaks out of the bands, something unusual has occurred and we’re in. Remember 2008-2009? Most of that movement was outside of the bands. Those types of situations can be very profitable.

Here are the details:

  • System: The Volatility Breakout System (it needs a new name)
  • Philosophy Behind It: When price gets volatile, we need to ride that extreme volatility to profit
  • Need Special Indicators? No, just Bollinger Bands™
  • Chart: Daily
  • Instrument: Forex EURUSD
  • Long or Short? Both
  • Long Entry: 1) Price must close above the Bollinger Bands™ (length 90, standard deviation 2); 2) Enter at open of next bar
  • Short Entry: 1) Price must close below the Bollinger Bands™ (length 90, standard deviation 2); 2) Enter at open of next bar
  • Stop Loss: 490 pips
  • Take Profit: 195 pips
  • Trade size: 1.0 lots
  • Hypothetical Profit: $119,411 (no compounding)
  • Hypothetical Max Drawdown: $15,588
  • Hypothetical account size: $10-20,000
  • Test Period: 2003-2019
  • Number of Trades: 119

Here’s the Report:

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A few important takeaways.

One, no compounding. Compounding would make this a big winner.

Two, there is a profit target on this system, and once the profit is taken, we are free to get into another trade. For example, we go Short and we make our target. But we’re still below the bands after hitting our target when the bar closes. In that case, we enter again at the Open of the next bar. And we’ll keep doing that as long as we’re above or below the bands. Theoretically, we could take several winning trades in succession–and this does happen sometimes. As long as the requirements are met, we keep going.

Here are a few examples of this:

As you can see, three Short trades are taken in a row because price kept hitting targets while below the bands.

Last, this was a very nice hypothetical result on the EURUSD. I would consider trading this with my own money.

However, these settings didn’t really work on any other instrument I tested. Even though the system is very simple, the targets and stops were not profitable on many other pairs.

Does that mean we found great settings for our instrument or does it mean we’re in trouble because it doesn’t work this way on anything else?

What do you think?

The best answer, of course, would be to trade it and see if the results look familiar. That’s always the best testing method.

Talk soon.

 

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Disclaimer:
It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples presented on these sites are for educational purposes only. These set-ups are not solicitations of any order to buy or sell. The authors, the publisher, and all affiliates assume no responsibility for your trading results. There is a high degree of risk in trading.

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.