A tale of two setups

Rather than talk about the recent market shenanigans, the chart of the Dow covering the last few months offer us a good chance to compare a low volatility setup against a higher volatility setup.

Regular readers of the blog will know that one of the key elements I look for in a setup is a contraction in volatility, together with a consolidation in price near the breakout level (read this post for more). 

I can easily find these setups in stocks (in the right market conditions!) but they are more difficult to find in a forex pair or an index. 

That said, these setups do come up from time to time, and when they do, because of their infrequency, they are instantly appealing. As an example of this, see this setup on the Euro (which featured historic low volatility) from a few years back.

This combination of volatility contraction and price consolidation is what made the setup which was created on the Dow Jones Industrial Average back in November worth a trade.

As you can see from the volatility factor indicator, this had contracted below its own 20 day moving average. Also, price had consolidated nicely just below the breakout level for a week before breaking out to new highs (highlighted by the green arrow), which was the signal to enter a long position.

From there, price continued to move up nicely in its trending, stable market 'state' before price broke down, triggering the trailing stop on 02 February.

All told, that long trade generated just over +9R profit.

Compare that long setup and its 'low volatility' nature with what the most recent price action is showing us. The volatility factor indicator has shot up - this and was more than double that November reading when it gave the latest short signal. 

And that that time, the 2ATR measurement, which I use to determine my initial stop distance and consequently position size, was also more than double its level in November.

This basically means that on the short signal, price would have to move a lot further to generate each unit of 'R' profit.

Because of this, the short signal itself did not interest me - along with the fact that there was no price consolidation and  no contraction in volatility before the breakout occurred. 

The final point I'd make goes back to your basic beliefs, your personality, strengths and weaknesses as a trader, and some points I've talked about my own trading for years on this blog.

I have always struggled to trade long-term, partly due to a lack of patience, but also due to the overall profitability for a decent length of time trading what many would consider to be relatively short-term parameters.

In particular, the longer-term you trade, then the wider the stops you tend to employ, and consequently when the trend 'bends' at the end, the bigger the giving-back of open profits before your trailing stop is hit. I have never been comfortable with that element.

Trading towards the short-term end of the trend following scale, you can be more prone to whipsaws. But that is a cost of doing business that I am prepared to pay.

In this game, you just have to do what works for you.