Volatility Contraction Pattern

The Volatility Contraction Pattern (VCP) is a well-known trading pattern that Market Wizard, Mark Minervini, identified and examined. The pattern’s assumption is that equities in long-term uptrends will pause and consolidate as some holders exit their positions and the stock is re-acquired by market buyers. The chart pattern can be employed in any time period and can create opportunities for powerful break outs. This allows traders to capitalize on prospective moves before they become popular.

Volatility Contraction Pattern’s Mechanics

The pattern’s background is straightforward. The stock had previously been advancing in an uptrend and had encountered some resistance. It then enters a period of consolidation marked by 2-6 retracements, each smaller than the previous one. As the chart travels to the right, the volume should normally decrease. The pattern culminates in a strong break out that is frequently long lasting. The key to identifying this pattern is that volatility must contract as the chart advances from left to right. This demonstrates that the available volume is declining and becoming scarce. Furthermore, the more dramatic the volume, the more likely the motion will be explosive. A rise in relative volume is observed beneath the breakout. Other designs that the VCP can take on include cup and handle patterns. The crucial point is that the volatility of the candlesticks must be reducing.

Volatility Contraction Pattern
Volatility Contraction Pattern

Characteristics of the Volatility Contraction Pattern

  1. The stock must be in an uptrend at stage 2.
  2. The base must go through a phase of price consolidation. After a stock has moved up in price, the consolidation (or correction) is a constructive chart pattern that allows the stock to digest the bullish price increase.
  3. Price volatility must fall below the basis (from left to right). The stock price will correct during this time of price consolidation.
  4. A series of smaller contractions are required to fix the price. Each contraction should be tighter than the previous one in order to depict the absorption of more weak holdings. This pattern should have between 2-4 contractions.

Before the pattern can be formed, the stock must be in a stage 2 uptrend and have reached an overbought or oversold region.

Demand is required for a stock to provide the correct setup for the VCP.

  • Demand indicates that the market has broken out of stage 1 and has become overbought.
  • The straightforward rule. Buying high and selling higher.

How to Spot a Stage 2 Uptrending Stock

A simple approach to identify a stage 2 uptrend:

  • Powerful impulse moves (looks like overbought).
  • Above all significant moving averages.

How Trading Low Volatility Periods Can Be Beneficial

  • This pattern can be traded both intraday and swing trading.
  • During a period of low volatility, your stop loss is usually tighter.
  • The risk to reward ratio is higher.
  • Before the breakout, you could look for a higher low while the stop loss could be small.

Conclusion

The market never travels in a straight line; it swings from low volatility to high volatility and back again. This is how the market cycle normally progresses, from low volatility to high volatility. When a stock breaks clear of the top resistance of the VCP Pattern, you usually purchase it. You may set the SL to the nearest Auto-Support/Resistance level (if not too far) below your buy point, or use a money management SL. You can also use a Custom Scan to look for stocks that have broken out of the Volatility Contraction Pattern.