Mark Minervini's trading method
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In today’s video, we discuss one of the most popular setups in swing trading - the volatility contraction pattern or the VCP.
The pattern was championed by the legendary trader Mark Minervini, in his first book, “Trade Like a Stock Market Wizard”, which we have covered in detail in this video.
Mark emphasized that the pattern has been at the forefront of his trading strategy and this helped him win the US Investing Championship once in 1997 and again in 2021, when he broke all records in the $1 million capital category with a 343% gain in a year.
But how did this pattern rise to prominence, and why is it so powerful in identifying high-potential stocks? Let’s dive in.
Before we delve into the details of the pattern, I want to make it clear the VCP is most useful to catch the continuation of a move in a trending instrument.
Therefore, an existing trend is the prerequisite for the VCP to be effective.
Mark Minervini identifies trends using his trend template that emphasizes the position of the stock relative to three key moving averages, the 50-day, 150-day and 200-day, the stock price’s distance from the 52-week low and high, and its relative strength as published in the Investors Business Daily.
Here is the full template. Feel free to pause the video to get a full grasp of the rules.
The basic idea is to find a trending price and join the next move up.
The VCP isn’t just about patterns; it’s about psychology. It reflects the behavior of institutional investors accumulating shares over time, leading to a breakout when demand overtakes supply. It works in all trading instruments including stocks, commodities, currencies, and cryptocurrencies.
The pattern is characterized by a series of price consolidations, where each successive pullback becomes smaller. This tightening of price action reflects reduced volatility, signaling that selling pressure is diminishing.
There are three stages in the pattern:
The first is Wide price swings, which is the Initial volatility as the stock forms a base. The wild swing is when the price is most violent. It generally occurs from the selling pressure of traders and investors who made money in the earlier move. As the price drops and the mark-to-market losses start to show, the traders gripped by uncertainty and fear, drive larger price swings.
At some point, the wild swings are supported by institutional buying marking the bottom of the wild swing stage.
Then comes the smaller pullback stage, in which each contraction is less severe than the previous one. Each contraction represents diminishing selling intensity as sellers exhaust themselves, while buyers grow more aggressive.
The number of contractions that occur in the price will generally vary from stock to stock. If the demand for the stock is high the contractions will be less severe and fewer. However, when the demand is low, or when the institutional investors are still figuring out the worthiness of the stock, the contractions will be severe and more frequent.
The last stage of the VCP is the breakout point.
In the best of the patterns, the late contractions are small, forming a very tight area when the price moves in a narrow range. The volumes at those points dry down as there is a limited supply of stocks near the high. As the demand outstrips supply at this juncture, the price breaks out with high volumes.
The best time to take an entry in the setup is when the price forms a tight area not too far from the previous highs, preferably in the 0-10% range.
The VCP can come in multiple shapes and forms, for example;
A triangle, in which the highs and lows of the contractions are joined through trendlines, forming the triangle.
A range or flat base, in which the trendlines run parallel when drawn on the highs and lows. This is something I look for in particular when trading breakouts.
Cup-with-handle, in which the price pattern resembles a cup with handle, with the handle being the tight area before the breakout.
The last is the flag, a powerful pattern that resembles a small flag when the trendlines are drawn connecting the highs and lows of the pattern.
Let’s see the entry and exit rules in the pattern.
Most of the time, the entry happens when the price breaks above the last contraction and touches new highs with volumes. The stop loss is placed at the low of that contraction. Creating a great low risk high reward opportunity.
These patterns work best in trending markets when you can clock high success rates. Having said that, if you can maintain low risk and high reward, even a low success rate can be profitable. You can see here that my win rate is nothing spectacular, but with a solid risk-reward ratio I still make solid returns.
The setups do work in sideways markets too, but not as well as they do in trending markets. Following an upward trend certainly improves the odds of success.
Some traders advise taking profits when you achieve the desired reward relative to the risk of the trade. So for example, if you bought a stock at a breakout of $100, with a $5 stop loss, and you are aiming for a reward of 3 times your risk, your ideal exit should be $115. My approach is slightly different in that I prefer to stay in the trend until the move is exhausted, allowing for higher reward with the benefit of finding the odd multi-baggers. Each method has its merit and comes down to personal choice, the key in either scenario is to control risk whilst achieving multiple reward.
Let’s look at some examples of how VCP has worked in recent times.
Here is the chart of Go Daddy Inc. from September to October 2024. The stock was in a strong trend, doubling in around a year. It then slipped into a VCP with three contractions. The first one was 11% deep, the second one was 6% deep and the third was 4% deep.
The stock broke out from the third contraction at $166 on this gap-up day. After the breakout, it retraced a bit but did not hit the stop loss which was placed at the low of the third contraction here at $159. The stock then rallied another 26% or $44 from the breakout point, which is six times the risk on the trade.
Here is the chart of another stock Royal Caribbean. This stock was also in a strong uptrend, doubling in nine months and then slipping into the VCP. This too broke out after three contractions with the first being the most violent when the price crashed 25% from the highs. However, it quickly recovered as sellers got exhausted and buyers took over.
The second contraction was 9% deep and the third was a tiny 3%. The stock then broke out with decent volumes with an entry price of $173 and a stop-loss at $167. It then rallied to $257, delivering a reward to risk 14 times in three months. With this type of trade you can be wrong many times but still end up in considerable profit in the long run.
Here is another chart of Spotify Technologies. The stock moved up over 4.5 times in a year and was still showing good strength as it drifted into the VCP. It saw two contractions of 16% and 8% along with a tiny tight area in which the price moved only 3% before breaking out on good volumes.
Because of the tight area, the stop loss in this case would have been very small. Such small stop losses can however be good as well as bad. Good because they keep the risk to the minimum, which all traders must aim to do. However, because the stop loss price is so close to the entry price, there is also a high likelihood of it being taken out if the market turns volatile. This is another reason as to why I personally prefer weekly charts.
In this instance, Spotify’s risk was 3% or $9 and the stock ran $150 after the breakout. That’s a whopping 16 times reward, delivered largely because the initial risk was very small.
Such patterns are great patterns for the active swing trader.
To demonstrate that the pattern works on other asset classes too, here is the chart of the most traded crypto asset - BITCOIN
Bitcoin saw several contractions in this consolidation with the last one here measuring 9% or $6400. Once it broke out at $73500, the price surged to $107,000 in a month delivering a risk-to-reward ratio of 1-to-5. That’s again a great ratio to achieve longer term success.
The key to trading VCP is to patiently wait for the right conditions to get the best low-risk trading entry. If the price is behaving too erratically at the breakout or the price breaks out without forming proper contractions, it’s best to move on to the next trade.
In trading you have to eliminate mediocre setups to improve your win rate. Doing this will also reduce the number of names on the watchlist, making the process easier and less overwhelming.
Once you have the knack of identifying and trading the VCP pattern, nothing can stop you from being a very profitable trader.
Over my 30 years of trading I use very similar principles, looking for high quality stocks showing strong momentum with low risk entry opportunities. Those familiar with the channel will have seen the progress of my equity chart seen here over the years, this was achieved by applying these principles. As a result, we developed a scanner to identify the perfect set up of such quality stocks, saving hours and hours of effort. For those interested you can access the scanner or follow my trades by using the links below.
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