by Kathy Lien

There are many ways to interpret changes in volatiles, but one of the simplest strategies is actually a visual one and requires nothing more than a keen eye. Although this is a strategy that is very popular in the world of professional trading, new traders are frequently amazed by its ease, accuracy, and reliability. Breakout traders can identify inside days with nothing more than a basic candlestick chart.

An inside day is defined as a day where the daily range has been contained within the prior day’s trading range, or, in other words the day’s high and low do not exceed the previous day’s high and low. There needs to be at least two inside days before the volatility play can be implemented. The more inside days, the higher the likelihood of an upside surge in volatility, or a breakout scenario. This type of strategy is best employed on daily charts, but the longer the time frame, the more significant the breakout opportunity. Some traders use the inside day strategy on hourly charts, which does work to some success, but identifying inside days on daily charts tend to lead to an even greater probability of success. For day traders looking for inside days on hourly charts, chances of a solid breakout increase if the contraction precedes the London or US market opens. The key is to predict a valid breakout and not get caught in a false breakout move. Traders using the daily charts could look for breakouts ahead of major economic releases for the specific currency pair. This strategy works with all currencies pairs, but has less frequent instances of false breakouts in the tighter range pairs such as the EUR/GBP, USD/CAD, EUR/CHF, EUR/CAD, and AUD/CAD.

Strategy Rules

Long

  1. Identify a currency pair where the daily range has been contained within the prior day’s range for at least two days (we are looking for multiple inside days).
  1. Buy 10 pips above the high of the previous inside day.
  1. Place a stop and reverse order for two lots at least 10 pips below the low of the nearest inside day.
  1. Take profit when prices reach double the amount risked or begin to trail the stop at that level.

Protect against false breakouts: If the stop and reverse order is triggered, place a stop at least 10 pips above the high of the nearest inside day and protect any profits larger than what you risked with a trailing stop.

Short

  1. Identify a currency pair where the daily range has been contained with the prior day’s range for at least two days (we are looking for multiple inside days).
  1. Sell 10 pips below the low of the previous inside day.
  1. Place a stop and reverse order for two lots at least 10 pips above the high of the nearest inside day.
  1. Take profit when prices reach double the amount risked or begin to trail the stop at that level.

Protect against false breakouts: If the stop and reverse order is triggered, place a stop at least 10 pips below the low of the nearest inside day and protect any profits larger than what you risked with a trailing stop.

When you know these key setups, spotting the lucrative Outlier trades gets crazy easy. Click here for your Outlier Roadmap.

Further Optimization

For further optimization, technical formations can be used in conjunction with the visual identification to place a higher weight on a specific direction of the breakout. For example, if the inside days are building and contracting toward the top of a recent range such as a bullish ascending triangle formation, the breakout has a higher likelihood of occurring to the upside. The opposite scenario is also true: if inside days are building and contracting toward the bottom of a recent range and we begin to see that a bearish descending triangle is in formation, the breakout has a higher likelihood of occurring to the downside. Aside from triangles, other technical factors that can be considered include significant support and resistance levels. For example, if there are significant Fibonacci and moving average support zones resting below the inside day levels, this indicates either a higher likelihood of an upside breakout or at least a higher probability of a false breakout to the downside.

Let us take a look at an example. Below is a daily chart of the euro against the British pound, or the EUR/GBP. The two inside days are identified on the chart and it is clear visually that both of those days’ ranges, including the highs and lows, are contained within the previous day’s range. In accordance with our rules, we place an order to go long 10 pips above the high of the previous inside day at 0.6634 and an order to sell 10 pips below the low of the previous inside day at 0.6579. Our long order gets triggered two bars after the most recent inside day. We then proceed to place a stop and reverse order 10 pips below the low of the most recent inside day at 0.6579. So basically, we went long at 0.6634 with a stop at 0.6579, which means that we are risking 45 pips. When prices reach our target level of double the amount risked (90 pips) or 0.6724, we have two choices – either close out the entire trade or begin trailing the stop.

More conservative traders should probably square positions at this point, while more aggressive traders could look for more profit potential. We chose to close out the trade for a 90-pip profit, but those who stayed in and weathered a bit of volatility could have taken advantage of another 100 pips of profits three weeks later.