The Volatility Contraction
Pattern (VCP): How To Day
Trade With It
The Volatility Contraction Pattern, or VCP, as it has come to
be known, has been popularized by Mark Minervini in his books
Think and Trade Like a Champion and Trade Like a Stock Market
Wizard. Despite the pattern’s success for swing trading, in
this post we’ll dive into how to recognize it for day trading
opportunities.
History of the Volatility
Contraction Pattern
The VCP, which dates back to Richard D. Wyckoff’s “wave
pattern,” carries a high rate of success when executed
properly. It essentially looks like a bull flag.
Many successful traders may refer to the pattern as simply a
“high tight flag.” However, that pattern implies certain
criteria that may not fit the VCP.
Regardless, the setup has obvious influence from the teachings
of Bill O’Neil and his famous book How to Make Money in
Stocks.
What Minervini discovered in his analysis of some of the
market’s biggest winners was their tendencies to pause during
new uptrends. This pause created a coiling action after the
initial upward force. It also offered a low-risk opportunity
to jump onboard for the next leg up.
“I stuck with the same style and strategy for so many years
that I got really good at doing that one thing. I was doing
the same exact thing I’m doing now — looking for stocks that
are in strong uptrends that are coming out of
1
consolidations.”
Mark Minervini
Regardless of the amalgamation of educators putting their own
influence on the pattern, it has a handful of shared criteria
for qualification. We’ll look at each one of these more in-
depth in a moment.
Why the Volatility Contraction
Pattern?
When analyzing different patterns or setups in the market, it
is imperative to manage risk. It is equally important to have
an edge.
Successful traders understand that the market is a game of
probabilities. Losses are inevitable. But an edge that
provides a higher reward/risk ratio can bring about obscene
profits over time.
You have no control over how much a stock goes up, but you
can, however, control the amount you lose on each trade.
Mark Minervini
This is where the VCP shines. It offers traders the ability to
take a position in a stock with growing momentum, yet with low
risk.
Just ask Mark who touts making over 33,554% in just 5 years
using only the VCP.
To that end, let’s look at each of the 5 criteria that creates
this explosive pattern.
What is the Volatility Contraction
Pattern?
1. Strong Underlying Demand
For a stock to create the proper setup for the VCP, there
needs to be demand. Plain and simple. And a lot of it.
To that point, there is no easier way to spot that demand than
a strong uptrend. This may seem counterintuitive to human
nature, but the best VCP patterns come from big prior moves.
It is at this point that many investors or traders feel as
though a stock is overbought. However, astute momentum traders
recognize the demand and take advantage of it. This is a
classic example of buying high and selling higher.
The following are a handful of flexible criteria to look for
in the foundation of an intraday VCP. Think of these as the
backdrop to the formation.
1. A premarket gap or explosive move off the open
2. Elevated Relative Volume compared to prior days’ average
3. The potential for a breakout on higher time frames
4. Underlying significant support (like a daily pivot or
moving average)
5. Inability to breakdown
Volatility Contraction Pattern Example –
WISH
Taking these 5 points, let’s use a recent intraday VCP example
in a strong-trending ticker, WISH.
Starting with the daily chart, we can begin building our case
for the “daily pivot” and “moving average” support markers. In
the image below, we see that we had an extremely bullish day a
few weeks prior.
WISH daily support levels
We can also see that the ticker is now “surfing” the 10-day
simple moving average. Each time it retreats to those levels,
volume recedes. This implies that supply is diminishing on the
daily chart.
From this daily back drop, let’s move a bit closer using the
30-minute time frame.
On the 30-minute chart, we see confirmation of the price
action holding higher lows. The volatility begins to contract
into the current day, suggesting an inability for price to
break down.
WISH 30-minute chart
Now that we have the higher time frames analyzed, let’s look
for the intraday action.
Pre-market Gap
In the following chart, we can see the prior day high, close,
and the after hours and pre-market action from the current
morning for WISH.
WISH premarket gap
Though volume is not shown, RVOL was above 100% for that
morning with over 5 million shares traded in the premarket.
Just before the open at 9:30am EST, the ticker is already
testing its prior day’s high. This is annotated on the chart.
With this in mind, we’d be wise to keep WISH on watch for any
kind of setup that might indicate an imminent breakout.
2. Recent Overbought/Supply Pressure
Given the 6% gap in the premarket for WISH, and the fact that
it is retesting the prior day highs, it wouldn’t be surprising
for some amount of profit taking or selling pressure off the
open. This is a common area to take profits in case the
breakout fails.
What this creates is an underlying compression, of sorts. It
is like two opposing forces trying to overcome each other.
Demand on the one hand, supply on the other.
Our job as traders is to identify who has the upper hand in
the battle. The Volatility Contraction Pattern helps with
this.
To see how this plays out as a day trade, let’s take a
snapshot of WISH shortly after the open.
WISH intraday VCP
We’ve drawn a line at the prior day’s high for a better
understanding of how important this level is. We noticed from
the premarket chart that resistance was showing up at this
pivot. So, it makes sense to include these key levels.
As the morning wears on, it becomes clear that the stock is
not breaking down. In fact, the supply injected at the
resistance line is being absorbed on dips.
3. Diminishing Supply / Decreasing
Volatility
After we see the “overbought” correction, we need to watch
closely to how the stock reacts. Does it find support again?
If so, where, and how convincingly?
These are questions that need to be answered with volume and
price action.
Per the notes on the chart, we begin to see “the wave”
tightening with higher lows. Each pullback contains less and
less volume/supply.
Finally, we coil into an area of tight price action on extreme
volume dry up2.
Volume Dry Up (VDU), is a popular way of finding lack of
supply in a healthy consolidation. This price action strategy
often precedes a “pocket pivot,” or break out. These
strategies were popularized by Gil Morales and Chris Kacher in
their book Trade Like an O’Neil Disciple.
Ideally, at this point in the consolidation, you want to see
the stock holding a support level like VWAP or a popular
moving average like the 10, 20, or 50ma.
WISH with 20ema, 50sma, and VWAP
As the stock consolidates into the Volatility Contraction
Pattern, we begin to see the influential support indicators
like the 20ema, 50sma, and VWAP have moved below the price
action. This is yet another red flag for short-biased traders
to run for cover. No pun intended.
4. The Breakout
As the force of demand begins to overpower the bears, it
becomes clear that bulls are going to win. And as we mentioned
above, this can be explosive depending on the pressure being
exerted by the bears.
The initial sign is the high volume bullish price bar
immediately following the VDU candle. After finding support
along the 20ema, the price pivots higher on convincing volume.
Volume returns with a vengeance after the tight coiling
action. Breakout buyers are jumping on the opportunity. At the
same time, shorts have a decision to make. Either cover before
the loss gets worse, or average up, hoping for a failed
breakout.
WISH VCP breakout
As the breakout continues higher, shorts are now underwater,
especially if they were averaged in from the prior day high.
They have only one choice to make.
As the short covering comes in, this fuels the bullish
character of the stock. In fact, in less than two hours, the
stock ran over 13%.
Swing traders would love to have those kind of gains in a
month!
VCP Variations and More Resources
While there are plenty of swing trading resources on the net
for VCPs, there are fewer links to daytraders employing this
strategy. The exception is Nate Michaud of
InvestorsUnderground.com.
Nate teaches a variation of this strategy called the ABCD
pattern in many of his free educational videos. If you have
time, you might check out his YouTube channel for more
information on how to spot these intraday opportunities.
How to Practice the VCP
Once you’ve seen the VCP, it is imperative to practice the
pattern in a simulator before putting real money to work.
You’ll want to identify when the pattern works, and when it
might throw false signals. After all, flag patterns can
resolve either way.
We suggest a few criteria to analyze each trade, similar to
what we have mentioned above.
1. Is the stock holding key moving averages and VWAP?
2. Are bulls showing signs of strength compared to the
bears?
3. Is volume higher than normal?
4. Could short-biased traders become trapped?
5. How close is the stock to support and resistance?
6. Does supply recede on pullbacks?
7. Do you get the breakout volume you’d expect to confirm
the breakout?
8. Does the breakout persist or fail?
These are just a handful of criteria you might consider
tracking as you spot these setups and trade them.
Over time, we’d expect you to collect a dataset with enough
trades to know your probability on the pattern. Otherwise, you
might as well be gambling.
As always, remember to create a trading plan for all your
trades. And best of luck!
