Volatility Squeeze: Squeeze Play Watchlist Methodology

What is a Volatility Squeeze?

A "Volatility Squeeze" occurs when the volatility of a stock falls below its recent levels. A fall in volatility usually means that the stock is in a period of consolidation and trending in a narrow range. When that period of consolidation ends, normal volatility will return resulting in a breakout to the upside or downside. If we can recognize a volatility squeeze situation, then we have the opportunity to place a long or short position order and profit from the breakout.

How can we recognize a Volatility Squeeze?

A Volatility Squeeze has usually been recognized by a narrowing of the Bollinger Bands. While this method has its merits, it lacks the objectivity necessary to provide a robust, objective, quantifiable trading strategy, We have developed a refinement of the methodology which allows objective identification of a Volatility Squeeze, We detect a "squeeze" when the 2 standard deviation Bollinger Band (BB) narrows to within the Keltner Channel (KC). Bollinger Bands are very susceptible to volatility changes while Keltner Channels are a smoother, trend following, indicator. Consquently, the narrowing of the BB to within the KC gives us a convenient means of algorithmically recognizing a drop in volatility.

While the BB are within the KC, we say the "squeeze is on". For trading purposes, we are interested in the moment when the squeeze comes off, meaning that the upper and lower BB move outside the KC again, which signals a breakout. Of course, the breakout can be to the upside or downside, but for our Squeeze watchlist we are interested only in breakouts to the upside.

A squeeze can occur while a stock is trending up or down. For our squeeze watchlist, we are only concerned with stocks trending up.

This graphic shows four possible situations in which a squeeze can occur and then come off. In scenarios A, B and C, CRAY would not have appeared on the SQZ watchlist because it was not ascending the right side of a cup, nevertheless A, B and C illustrate the circumstances under which a squeeze can occur. In scenario D, CRAY would have been on the watchlist and an alert would have been issued.

Selecting Stocks for Our Squeeze Watchlist

When we select stocks for our cup-with-Handle (CwH), Double Bottom (DB) or Head and Shoulders Bottom (HSB) patterns, we first look for stocks that have formed the left side of a cup and are starting to ascend the right side. This behavior is common to all three patterns and we place these stocks on an internal watchlist we call Basewatch. To select stocks for the Squeeze (SQZ) watchlist, our algorithms examine each stock on Basewatch to determine if the squeeze is on for each stock. To remove the likelihood that the stock could breakdown from the squeeze we also look at the momentum of the stock and the slope of the momentum curve. If both momentum and the slope of the momentum curve are positive, then these stocks go on the SQZ watchlist.

CRAY Squeeze

Determining Breakout Price

For the squeeze to come off and give a buy signal, the price must rise to the extent that the Bollinger Bands move outside the Keltner Channel. This price can be calculated and is published on the watchlist as the breakoutprice.
value. So while in a squeeze we can calculate the price at which the stock must close at the next session to lift the upper BB above the upper KC. This price now becomes the breakout price.

Squeeze Alerts

As with our other watchlists, we monitor the real-time price during the next session and issue an alert if the breakout price is reached.