Using Bitcoin as an example of why I love volatility contraction

On my last post, I talked about the recent big winning trade in Bitcoin on the long side from earlier this year,which generated a +21R profit. Yesterday, Bitcoin gave a short signal as price dropped. 

Would I have taken this signal? 

No. 

Let me explain why.

Given that I trade predominantly stocks in the UK, the US and Europe, as well as other instruments, I could have thousands of breakout setups to look at at any time. Therefore I want some sort of filter which could help me identify those offering a better potential risk:reward opportunity. For this, I use volatility measurements.

If we look at the current chart of Bitcoin we can clearly see the increase in volatility, as denoted by the volatility factor indicator, as well as the 2ATR measurement.

When I took the breakout in Bitcoin back at the end of March, the 2ATR reading on entry was 182. The updated chart shows that the current 2ATR reading is 1,846 - a ten fold increase!

As a result of this, had I taken this short signal, even if Bitcoin now plunged down to zero, the maximum profit I could have achieved would have been just over +5R.

If price had broken out to the upside based on the current entry level at 13,341, for me to achieve a similar profit equivalent to +21R, price would have to surge more than 40,000 points to over the 53,000 level!

The 2ATR measurement is a key metric for me. This is used to determine my initial stop distance on entry, and because I risk the same amount of cash equity (in percentage terms) on each trade, this directly affects my position size. 

When evaluating a setup, the basic point to remember is that, the higher the 2ATR level at entry, the further price has to move in my favour to generate each unit of R in profit.

Now, it is quite right to say that, as the underlying price of a stock or instrument increases, then you would also expect the base numerical value of the 2ATR measurement to also increase. And clearly the current price of Bitcoin is higher than earlier in the year. So, to 'normalise' this, in the chart below I show the 2ATR measurement expressed as a percentage of current price.

This shows that, in the late March entry, the 2ATR measurement was equivalent to less than 5% of the current price, and was the lowest reading for several months. As of today, this is over 19%. 

This is just the use of basic maths to help try and skew the odds in my favour, and is a great example of why I love looking for volatility contraction on a setup.