The Volatility Contraction Pattern (VCP) is a technical analysis strategy that can help identify stocks with strong buying momentum after a period of consolidation. This strategy follows a “buy high, sell higher” approach, aiming to take advantage of strong breakouts following a tightening price range.

We have broken the VCP trading strategy down into four stages. You can find the full blog by clicking here.

A short summary of the VCP trading strategy

Step 1: Identifying high demand

Look for stocks that have been in a strong uptrend and show signs of building momentum.

Step 2: Contraction from Left to Right

Stocks experience selling pressure, leading to a period of consolidation. The trading range becomes smaller with each new retracement, indicating a contraction in volatility.

Step 3: Decreasing volume

Price range tightens, the volume decreases. You may also notice rising lows, which suggests a decrease in selling pressure.

Step 4: Breakout

In this final stage, demand surpasses supply, resulting in a breakout accompanied by a significant bullish bar.

These four components are essential for trading the volatility contraction pattern (VCP). However, it’s important to remember that the market is constantly changing, and traders should consider other patterns and fundamentals as well.

We have five extra tips that can help boost your win-rate and reward ratio when trading the VCP. These tips are based on real market examples and the experience of professional traders.

5 Tips To Maximize Win-rate & Reward Ratio Trading Volatility Contraction Pattern (VCP)

Tip 1: The current price is 25% within the 52-week high

If the volatility contraction pattern forms near the 52-week high, it indicates greater momentum.

This suggests that selling pressure will be lower when the price breaks out to a higher level. Conversely, if a similar pattern forms near the 52-week low, the breakout and rally may be weaker.

Tip 2: Look for price breakouts accompanied by volume breakouts

After confirming a price breakout from a previous resistance level, it’s important to also see an increase in volume. This indicates strong demand for the stock and makes it more difficult for the price to pull back below the previous resistance level. Without a volume breakout, the breakout may be false or manipulated.

Tip 3: Consider entering early for a better price

While many traders wait for confirmation of a breakout before entering, entering at the last retracement can provide a price advantage of 5–10%. This allows for a more favorable stop loss and increased confidence in holding the position.

To enter before most retail traders, the Tradedots indicator can be used to identify reversal patterns. Enter half of the position when signal appears, and if the breakout is confirmed, enter the rest.

Tip 4: Utilize Simple Moving Averages (SMAs)

A good volatility contraction pattern (VCP) is often formed during an ascending market condition. By using SMAs such as the 50-day, 150-day, and 200-day moving averages, you can determine if the price is in an uptrend. Stocks in an upward channel have a higher probability of breaking out with greater momentum.

Tip 5: Consider liquidity and market capitalization

Before trading the pattern, ensure that the stock meets the criteria mentioned above and also has sufficient liquidity and a diverse shareholder base.

Stocks that are illiquid or have a centralized shareholder structure can be easily manipulated, leading retail traders to lose money.

A general guideline is to look for stocks with a market capitalization above $300m threshold and a daily trading volume above 50k. However, these thresholds may vary across different markets, so always conduct your own research and make informed decisions.

Bottom line

In conclusion, the VCP is not a guaranteed winning strategy and should be used in conjunction with other forms of technical and fundamental analysis. Risk management is crucial, and stop-loss orders should always be used. The VCP can be applied to various timeframes, but it is often most effective on daily or weekly charts.

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Disclaimer: The information provided in this article is for educational purposes only and should not be considered as financial advice. Trading involves risk, and it is important to conduct thorough research and seek professional guidance before making any investment decisions.