How do volume and volatility affect breakout trade decisions?

When trading shares, bonds, commodities, or futures, market participants can monitor trading volumes to inform breakout trading strategy. By assessing the trading volume accompanying a price movement, traders are able to validate the strength and sustainability of the move as part of their technical analysis. Essentially, they’re looking to whether a price move is supported by market participation, which makes the move more reliable and significant.

Forex is not traded via a centralised exchange, so there’s no reliable way to measure trading volumes to accurately capture positioning shifts in the market in real-time, as with stocks, bonds, commodities, or futures. Instead, traders may monitor implied volatility instead of volume to inform breakout trading strategy.

The impact of volume on breakout trade decisions

When a trader spots a potential breakout, they will look for an increase in trading volume as confirmation of the breakout. If the breakout or breakdown is accompanied by higher-than-average volume, it means more market participants are involved, and it’s likely to be a valid and sustained trend change.

It’s important to also pay attention to volume divergence. For example, if prices are rising but volume is decreasing, it might indicate weakening buying interest and that the upward trend could be losing momentum. Conversely, in a downtrend, increasing prices accompanied by decreasing volume may indicate weakening selling interest.

Traders use volume patterns as potential confirmation signals. For instance, a spike in volume after a period of consolidation or low trading activity might indicate a potential breakout. On the other hand, decreasing volume during a consolidation phase could signal a lack of conviction and a false breakout.

You can also use volume confirmation to help identify trend reversals. For example, in a downtrend, a reversal accompanied by a surge in volume can suggest a stronger shift in sentiment and increase the likelihood of a sustained uptrend.

Example

Let’s say you observe that shares of ACME Corporation have been trading within a range between $50 AUD and $60 AUD for an extended period, indicating a consolidation phase. During this phase, the trading volume has been relatively low, which you believe suggests a lack of strong conviction among market participants during the range-bound movement.

When you see the price break above $60 AUD (the resistance level), you think this might signal a bullish breakout. To help you confirm this, you examine the volume data. If you see a noticeable increase in trading volume as the price breaks above $60 AUD, it provides volume confirmation and suggests that the breakout has support from a larger number of market participants, at which point you might decide to enter a long (buy) position, anticipating further upward movement.

Of course, being a responsible trader, you will also employ risk management techniques, setting a stop-loss order just below the breakout level ($60 AUD) to limit your potential losses.

As your trade progresses and the stock price continues to rise, you keep checking volume. If the uptrend is supported by increasing volume, it suggests a healthy and sustainable trend. However, if you see a substantial decrease in volume as the stock price approaches a significant resistance level or shows signs of weakening, it may signal a loss of buying interest. In such a case, you might decide to exit the trade.

Implied volatility in breakout trading strategy

Implied volatility measures the expected price range over a given period. A simple rule of thumb is: when prices leave a consolidation, look for breakout confirmation by a rise in short-term (overnight and 1-week) implied volatility measures.

Forex traders can't directly see implied volatility like options traders can, but they can get an idea of market expectations by looking at related factors. For example, they might check the prices of options on a currency pair or use volatility indicators like Bollinger Bands to indirectly get a sense of whether or not the market expects bigger price movements. In other words, they use the information available to gauge how much uncertainty or potential volatility is expected in the market.

Another tool that traders might use to assess implied volatility is average true range (ATR).

Average True Range

The average true range (ATR) indicator is used to track volatility in a given time period. It moves up or down according to whether an asset’s price movements are becoming more or less dramatic. A higher ATR value represents greater volatility in the underlying market, and a lower ATR represents the opposite.

By tracking volatility in a given time frame, you can use ATR to help you gauge when price movements might become more or less sporadic as volatility increases or decreases.

The ATR works by creating an average of the true range (the classic measurement of the range of movement in an asset’s price). The true range indicator is taken as the greatest of the following:

Current high, less the current low
The absolute value of the current high, less the previous close
The absolute value of the current low, less the previous close

The ATR smooths out the true range data to give traders an average, usually over 14 days, to offer a simple way of understanding how much an asset's price might change. It’s a tool that helps traders to gauge how volatile or stable an asset is.