How to Time Your Trade with Pinpoint Accuracy - The Volatility Contraction(VCP) Pattern

February 23, 2015

Most investors cannot resist the urge to buy stocks at the wrong time, usually when the price is
declining. I’m constantlyasked whether I like this stock or that stock, and 99 percent of the time my
reply is, “I wouldn’t buy it here.” The reasonfor this is that I have a strict discipline that only allows
me to buy at a very specific point: the point at which rewardoutweighs risk. How do I identify this
point? If there is any one commonality or Holy Grail that I follow and practice regularly, it is the
concept of volatility contraction.This is a key distinction that I look for in almost every trade I
make. A common characteristic of virtually all constructiveprice structures (those under
accumulation) is a contraction of volatility accompanied by specific areas in the basestructure where
volume contracts significantly. The main role that VCP plays is establishing a precise entry point at
the line of least resistance. In virtually all the chartpatterns I rely on, I’m looking for volatility to
contract from left to right. I want to see the stock move from greatervolatility on the left side of the
price base to lesser volatility on the right side.

The Contraction Count

During a VCP, you will generally see a succession of anywhere from two to six contractions, with the
stock coming off initially by, say, 25 percent from its absolute high to its low. Then the stock rallies a
bit, and then it sells off 15 percent.Then buyers come back in, and the price goes up some more,and
finally it retreats 8 percent. The progressive reductionin price volatility, which will be
accompanied by a reduction in volume at particular points, eventually signifies that thebase has
been completed.

As recently as just last week, we added CBPO to our MPA Buy Alert list as it was setting-up a buy
point in aclassic VCP pattern. The VCP pattern started on 11/06/14 and the breakout occured on
2/17/15.

As a rule of thumb, I like to see each successive contraction contained to about half (plus or minus a
reasonable amount)of the previous pullback or contraction. The volatility, measured from high to
low, will be greatest when sellers rush totake profits. When sellers become scarcer, the price
correction will not be as dramatic, and volatility will decrease.Typically, most VCP setups will be
formed by two to four contractions, although sometimes there can be as many as fiveor six. This
action will produce a pattern, which also reveals the symmetry of the contractions being formed. I
call thesecontractions Ts. Not all price patterns display VCP characteristics. There are some
variations, such as the square-shaped Darvas boxpattern, or a flat base structure that is four to seven
weeks in duration. With this type of base, there is no real volatilitycontraction as it remains a tight
and narrow pattern or box, moving in a sideways range with about a 10 to 15 percentcorrection
from high point to low point. Or a stock could undergo successive consolidations, with varying
degrees of volatility to produce contractions, for example, from a 25 percent correction, to a
10 percent, to a 5 percent, and so forth,which would be indicative of a classic VCP progression.