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How to Time Your Trade with Pinpoint Accuracy – The Volatility Contraction (VCP) Pattern February 23, 2015 Return to Blog Home Page Most investors cannot resist the urge to buy stocks at the wrong time, usually when the price is declining. I’m constantly asked whether I like this stock or that stock, and 99 percent of the time my reply is, “I wouldn’t buy it here.” The reason for this is that I have a strict discipline that only allows me to buy at a very specific point: the point at which reward outweighs risk.
How do I identify this point?
If there is any one commonality or Holy Grail that I follow and practice regularly, it is the concept of volatility contraction. This is a key distinction that I look for in almost every trade I make. A common characteristic of virtually all constructive price structures (those under accumulation) is a contraction of volatility accompanied by specific areas in the base structure where volume contracts significantly.
The main role that VCP plays is establishing a precise entry point at the line of least resistance. In virtually all the chart patterns I rely on, I’m looking for volatility to contract from left to right. I want to see the stock move from greater volatility on the left side of the price base to lesser volatility on the right side.
The Contraction Count
During a VCP, you will generally see a succession of anywhere from two to six contractions, with the stock coming off initially by, say, 25 percent from its absolute high to its low. Then the stock rallies a bit, and then it sells off 15 percent. Then buyers come back in, and the price goes up some more,and finally it retreats 8 percent. The progressive reduction in price volatility, which will be accompanied by a reduction in volume at particular points, eventually signifies that the base has been completed.
As recently as just last week, we added CBPO to our MPA Buy Alert list as it was setting-up a buy point in a classic VCP pattern. The VCP pattern started on 11/06/14 and the breakout occured on 2/17/15.
As a rule of thumb, I like to see each successive contraction contained to about half (plus or minus a reasonable amount) of the previous pullback or contraction. The volatility, measured from high to low, will be greatest when sellers rush to take profits. When sellers become scarcer, the price correction will not be as dramatic, and volatility will decrease. Typically, most VCP setups will be formed by two to four contractions, although sometimes there can be as many as five or six. This action will produce a pattern, which also reveals the symmetry of the contractions being formed. I call these contractions Ts.
Not all price patterns display VCP characteristics. There are some variations, such as the square-shaped Darvas box pattern, or a flat base structure that is four to seven weeks in duration. With this type of base, there is no real volatility contraction as it remains a tight and narrow pattern or box, moving in a sideways range with about a 10 to 15 percent correction from high point to low point. Or a stock could undergo successive consolidations, with varying degrees of volatility to produce contractions, for example, from a 25 percent correction, to a 10 percent, to a 5 percent, and so forth, which would be indicative of a classic VCP progression.
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