**Although we’ve spoken about breakouts and fakeouts previously, we did that in application to some strategy or tool of technical analysis. It this current chapter I offer you a bit more about the trading of breakouts or fakeouts themselves and some indicators that you can use to more clearly identify a breakout and/or fakeout.**

*Commander in Pips:***That’s great. After those topics that we’ve discussed and told about breakouts, I wanted to ask you about this. Is there any way to clearly identify a breakout? Since sometimes this is a most important moment in the trade.**

*Pipruit:*

**You’re right. As we already know, a breakout is strong move of price outside of some levels that held the market for some time and moving beyond these levels is called a breakout. These levels could be different – horizontal support/resistance, i.e. some range, Fib levels, pivots, trend lines etc. Generally speaking our task is to enter right at the moment of breakout and then riding on it, harvesting all of the breakouts’ profit until volatility will decrease.**

*Commander in Pips:***Volatility? What is it, and why volatility?**

*Pipruit:***Well, on other markets most traders use trading volume or tick volume for that purposes. The major rule tells that if a breakout accompanied by great trading volume then it more probably will be true, and vice versa, if breakout is not supported by growing volume, it is more likely to be false.**

*Commander in Pips:*Since one of the unwelcome properties of the spot Forex market is the inability to see true trading volume, we have to use different indicators. But these probably are even more useful. These indicators measure volatility instead of trading volume. This is extremely important in option strategies, but also could be used for breakouts classification.

**And why we can’t use volumes?**

*Pipruit:***Because of spot Forex structure. You surprise me annoyingly, we’ve discussed it with details already, and I suggest you re-read comparison of Futures and Spot FX markets as well as Spot FX with equities.**

*Commander in Pips:***Sorry, Sir, I’ll definitely do that.**

*Pipruit:***This ship has sailed, so for the coming weeks you’ll be on probation – two extra duties! Review all those early lessons again and report to the mess hall to clean the dishes.**

*Commander in Pips:***Oh, now I’ll finish my days in closet…**

*Pipruit:***…and will remember about difference of FX Spot and Futures.**

*Commander in Pips:*So, as we’ve said, our foundation on trading breakouts is not just a risk management and application of other tools that we’ve studied but also using some specific indicators that allow us to judge about volatility. If the market shows some solid moves during a short time period then volatility is treated as high, otherwise volatility is low.

**And why is it so important?**

*Pipruit:*

**Do you want another extra duty?**

*Commander in Pips:***No Sir.**

*Pipruit:***Then don’t interrupt me while I’m explaining the answer to your questions.**

*Commander in Pips:***Oh, sorry, please continue.**

*Pipruit:***When you see such kind of price action that is typical for great volatility – big swings and sometimes in both directions, you can just jump in and many traders do that, because it’s very attractive to get solid profit in short-term, but this is particularly dangerous since it very often makes it tempting to take high risk trades.**

*Commander in Pips:*So, our primary task here is not to just follow the volatility and jump in the water with closed eyes. Our first task is to estimate when volatility is low and its growth become very probable. That will give us two advantages – we will be able enter during a calmer time in the market and if some breakout will take place, it will have greater chances to be real, since volatility stands and low levels.

Let’s start first from the volatility itself and description of some indicators that allow us to judge about it.

**Volatility, what is it?**

Since we will not deal with options, where volatility is a major parameter, we will take a look at it just lightly. In general, volatility is an average deviation of price from its average value – mean value, during some predetermined period of time. Time period is important, since weekly and yearly volatility could be different and as a rule will be different. Also it is important to base decisions on what particular period volatility is calculated. Since, you can get different numbers if you will calculate volatility based on most recent 15 days, or 15 days before them. Also you can annualize any volatility and express it in terms of a yearly volatility number.

**Sir, please stop! My head will explode soon.**

*Pipruit:***Ok, it’s better to show you formulas and examples. Let’s calculate volatility manually. In general volatility is a standard deviation of percent price changing from average price changing but not just a price from its average:**

*Commander in Pips:***Volatility = (Variance)^0.5,**

Variance = ∑(Xt –Xav)^2/(t-1)

Variance = ∑(Xt –Xav)^2/(t-1)

**Where Xt – percent price change from previous value;**

Xav – average price change;

t - Number of values.

Xav – average price change;

t - Number of values.

So it looks awful, but in reality this is rather simple.

1. We need close prices, say, for the recent 10 trading sessions. You can use any number, but better to not use less than 5:

2. Now we need to estimate percent changes of price. For that purpose we just need to divide followed number by previous. For instance 1.4380/1.4267 = 1.0079204 and so on:

4. Now we need calculate sum and mean values of logarithmic percent deviations, that’s simple:

5. Now we calculate the numerator of variance formula – this is last column in our sheet. For example, the first row results as (0.788917416-0.1631231)^2 = 0.391618526:

6. Calculate its sum…

**√(3.30203681/9) ~ 0.61%**

That’s daily volatility, since we’ve calculated it based on daily deviations. But how to express it in terms of weekly volatility or yearly volatility? Very simple, just multiply it on square root of days in week and/or year. So, weekly volatility will be:

**0.61*√5**= 1.36%, while yearly = 0.61*

**√250**=

**9.64%**. The most common in application is yearly volatility, because it used in calculation of options value.

**Hm, you’re right, it does not look too scary, especially with Excel software. But, Sir, and why we use number of 5 for week and 250 for year?**

*Pipruit:***Because, the common practice is to use number of business days in week so as in year. Still, some traders use 7days for the week and 360 or 365 for the year.**

*Commander in Pips:***And how to calculate yearly volatility, if you use weekly closes instead of daily?**

*Pipruit:***Very simple. How many weeks in year?**

*Commander in Pips:***Approximately 52 weeks.**

*Pipruit:*

**So, you need to multiply weekly volatility on square root of 52 to get yearly one.**

*Commander in Pips:***Cool. And is there some software that could calculate this volatility automatically.**

*Pipruit:***Sure, but not in all programs. For instance, MT4 does not have it built in. Still, we show the algorithm so you can program it yourself. What we’ve calculated is called Historical volatility. Here is the chart with this indicator:**

*Commander in Pips:*

*Chart #1 | Daily EUR/USD and Historical Volatility(10) indicator*

It shows yearly volatility that based on last 10 days. Here we can change number of periods that used for calculation. See – we do all correct, since indicator shows the same number that we’ve got in our manual calculation.

**Cool!. And how it will help us to trade breakouts?**

*Pipruit:***We will speak about it a bit later. Now we’ve estimated what volatility is, and the first indicator for its calculation. Now let’s discuss others, they are more known than this one.**

*Commander in Pips:***MA is poor for volatility estimation**

Some traders use MA as indicator of volatility, precisely speaking - its slope and deviation of price from the MA’s line, since MA shows average price value for some predetermined period. But it’s worthy to note here that this method is not quite correct and mostly based on the sharp eyes of a trader rather than on some numbers. We need to see not the average price, but average percent deviation and MA does not show that. All that a trader could say is that if the market deviates too much from MA – then probably it will gravitate back to it. Second, if th slope of MA becomes greater – this usually happens when market turns to trend motion, then changes of prices will become greater and probably volatility has become greater. But using onlyMA, a trader could not tell that definitely, since even in the trend, volatility could decrease and as a rule decreases – just look at chart #1. So, for our purpose MA is a poor indicator. There are some much better indicators that are also known as well as MA. For example, there is Bollinger Bands…

**Volatility by Bollinger Bands**

This indicator is much better at showing volatility level. Although it shows variance not of deviations but price itself, still even this way could give some information about volatility. Since we’ve talked about this indicator much, I just want to remind you how it works. In fact it calculates standard deviation from mean value during some period that you appointed in parameters of this indicator. The bands shows +1deviation (upper band) and -1deviation (lower band) from average price, i.e. MA. Also you can choose how many deviations you would like to apply and to see on the chart. When volatility reduces, then the value of deviations itself becomes smaller, hence, the bands range become tighter. Once volatility starts to increase and price movement is stronger and stronger deviates from average – the value of deviation itself also increases, and, hence the range between bands becomes wider. How can it us? When band range ultimately contracts – it tells us that volatility is low and if your analysis tells that the market could show some breakout, then, probably this breakout has nice chances to be true. When range is expanded or already stands wide, it tells us that volatility is solid already, and it could lead to fake out just due great amplitude of current market swings.

**Average True Range**

This is another useful indicator for estimating volatility on the market. It’s not normalized and takes the moving average of the true range over the specified period:

**True Range = True High - True Low.**

True High = The greater of the current bar's high or the close of the previous bar.

True Low = The lesser of the current bar's low or the close of the previous bar.

True High = The greater of the current bar's high or the close of the previous bar.

True Low = The lesser of the current bar's low or the close of the previous bar.

This indicator can easily replace Historical Volatility indicator. Besides, it’s much simpler. Usually this indicator is applied to longer time frame charts – daily and longer. The most common parameters are: 5; 13; 21; 55 or 65.

**Average True Range continued**

Here are major rules for using it:

1. If ATR reaches high numbers, it tells that volatility is high currently and its reducing is very probable. If, vice versa, ATR is close to low value, then volatility is low and we can count on its growth;

2. If ATR shows a downward move and the market stands in consolidation then we can count on a breakout. ATR does not show the direction of the breakout, it just tells us that the market is building aup energy and that it is very probable that this breakout will be real;

3. If you apply 5 and 13 periods for ATR, then it will be quite choppy and peak values are important here. So, if ATR has reached peak value as well as market shows new significant high or low, then it could lead to reversal;

4. If market shows some breakout after long-term decreasing of ATR, then it could lead to significant move in direction of breakout.

Here is how it looks:

*Chart #2 | Weekly EUR/USD and ATR (21)*

Still this indicator has some disadvantages. This is a type of indicator where interpreting it is more of an art than a science. The indicator itself is conservative and gives you a bit of a lagging picture. But still, it is very useful.

Here is another example, but on 4-hour chart:

*Chart #3 | 4-hour EUR/USD and ATR (21)*

In other words, ATR is indicator that is worthy of your attention to it.

The next indicator is also a very useful tool, although it also does not show direction of possible move, but it could tell you probable distance that market could pass after breakout. This is the Range of Price Channel.

**Volatility by Range of Price Channel (RPC)**

This indicator also is not normalized and its formula is very simple:

**RPC = Absolute value of (High-Low n-periods ago).**

So, if you period is 10, then it RPC will show you difference between current high and low 10-periods ago, etc. But why this indicator is so important? Because any market has its own pulse frequency and some minimums and maximums levels that hold due to the nature of a particular market - so as with harmonic number. That’s why when the market reaches these levels RPC could tell you what to expect – breakout or sideways consolidation.

Here are the major rules of RPC application:

1. The most common parameters are 5;10;21;55

2. On trending market RPC shows stability or gradual increasing in value;

3. On sideways consolidations RPC shows decreasing or stability at low values;

4. Although it is not normalized, it usually holds in some range, like the DOSC indicator due to the nature of the particular market;

5. Indicator tends to return to its previous highs and lows. They itself could give a sign that the current move is close to an end;

6. This indicator gives quantitative parameter of true breakout – usually if RPC chances for 2-2.5 times compares to current value, it tells about future price move. As a rule this move lasts for 2/3 of difference between highest and lowest value of RPC;

7. RPC tells what price move is not just an occasion fluctuation – it equals 0.5 of minimum value. If that indicator changes on that value it tells that trend development is possible.

**Well, it’s all clear except two last points…**

*Pipruit:***Ok, I’ll show you on the chart:**

Commander in Pips:Commander in Pips:

*Chart #4 | Daily EUR/USD and RPC (21)*

The average low of RPC is about 200-250 pips. So, according to our point 7 move of indicator for 100-130 pips could not be just occasion. In the first rectangle we see that the indicator drops significantly from 1292 to 111, or for 1292-111 = 1181 pips. Multiply 1181*2/3 = 787 pips – this move we can expect from further price action in the direction of breakout. The move was almost precisely for that value – from 1.3750 to 1.29.

History has repeated, but now in another direction. RPC has risen obviously more than just for 150 pips in the beginning of 2011, precisely speaking for 850 pips. Hence our expected move is 850*2/3=560 pips, market has shown even greater move from 1.39 (after breakout) to 1.48

Although you can experiment with that indicator, it’s rather specific and more suitable for options trading and estimating possible changes in volatility. It is needless to say that you should not trade only based on it. Still you can try to deal with it also. But I suspect that your choice will be BB and ATR just because they exist in MT4 software. But all of these indicators mostly for reference, only as add-ons to other analysis tools. Personally, as a rule I use Historical Volatility and ATR.

Is there anybody willing to write the Historical Volatility Indicator as described by Sive and post it here for all of us to use?