Are You Using the Right Trading System for the Current Market? By Martha Stokes, CMT Most traders understand that the market trends up, down, and sideways. Just as important is an understanding of the CONDITION of each of those trends. Before choosing a trading system, ask yourself:
What is the dominant TRENDLINE PATTERN of price movement and is it strong, moderate, or weak? What is the energy of the trend—insipid, weak, moderate, or strong? What is the daily bias? What is the long term direction? What is the long term strength?
Your answers to these questions make up the Market Condition for the current market you are trading. There are 6 Primary Market Conditions: Velocity Moderately Trending Platform Building Bottoming Topping Trading Range Once you have identified what market condition you are trading, you can then select the appropriate trading system for that market. No matter how you trade the market, you are using a trading system. A trading system is not a strategy, a software program, or an entry signal. It is a set of rules and parameters that were developed around a formula of indicators and price action for a specific type of market condition. Often, a trader will complain that a strategy doesn’t work. These traders struggle with meager profits that seldom pay the bills. They wander from seminar to seminar hoping to find that ‘perfect’ strategy. It’s not the strategy that is wrong. It’s the market condition under which the strategy is being applied that is not right. Strategies work best when applied to the proper market conditions for which they were designed. Before you can choose a strategy for the current market conditions, though, you must thoroughly understand 2 important aspects of trading: 1. What a trading system is
2. Which system works under what market condition For short-term retail traders (that’s me and you), there are 5 primary types of trading systems: Note: There are other systems for intermediate and long term investing.
Trending Trading Systems Counter-trending Systems Hedging Systems Breakout Systems Trading Range Systems
Trending Trading Systems Trading systems that are based on trending markets are the most popular and prevalent of all types of trading systems. The first trending market-based systems were developed in the early 20th century during the period when technical analysis was born. The first trending systems used moving averages as the basis for buying, holding, and selling stocks. Today’s trending systems are far more sophisticated and many are computer-generated entry and exit signals. However, trending systems fail during certain market conditions because of the specific parameters that form the basis for a trending system.
A trending trading system assumes that the stock market or certain sectors are moving in a strong uptrend or strong downtrend. A strong uptrend or downtrend is defined as a trend that has at least a 35° angle of ascent or descent with brief retracements or bounces and/or weak consolidation patterns that form as the stock or market moves up or down in that trend pattern. These periods of retracement or consolidation are short in duration and are shallow adjustments to price due to profit-taking or resting phases of the uptrend.
The stock market trends (up or down) about 30-35% of the time. During these phases of market conditions, something triggers speculation and greed or speculation and panic for the downside. This hyper state of emotion creates a surge of buying or selling that causes stocks to run faster as price moves up. Trending systems take advantage of this velocity action of price, often creating large point moves in a few days. To take advantage of these periods when the market is moving fast, technical developers created trending systems. They are popular because most traders want fast, easy money and they appear on the surface to be simple to learn and apply.
The downside to trending systems is that they require a fast-moving market or a speculative market with velocity to work optimally. Many trending systems require a speculative market where stocks move dynamically upward with significant gains. Trending systems can be used for swing trading, intra-day or day trading, momentum trading, or any fast-paced style of trading. Stops are usually tight, as most trending systems employ the theory that there will be many very small losses and a few large profit trades. A trader must be prepared to accept this kind of risk in his/her trading and must have sufficient capital to trade larger share lot sizes to offset trading costs. The downside to ALL trending systems is that they only work when the market is trending up or down. The market only trends up or down about 30% of the time. If you attempt to use a trending-based trading system during a sideways or choppy market condition, you will continually be whipsawed out of trades with small to moderate losses resulting in a significant loss of capital over time. If you fail to recognize that the market conditions are not conducive to trending system trading, you are at risk of losing the bulk of your capital base. Breakout Trading Systems The first breakout trading systems began to appear during the early 1950s when the market was behaving much like it is today. The market was just beginning to win favor again after the devastating stock market crash of 1929 and lack of interest during WWII. Instead of a speculative market as occurred in the late 90s, the market of the 50s and 60s was based primarily on value. Therefore, Breakout Systems were ideal for that market. Breakout trading systems are based on the premise that the market builds platforms before moving up suddenly, without much warning. This can also occur to the downside, but most breakout systems are used in uptrends. A market will build platforms when it is a value-driven market rather than a speculative market. Traders, especially the large lot traders, will buy based on company projections for the next quarter. Thus, platforms form. Sudden price surges often coincide with earnings report release dates. A technical analyst can see the large lot buying that commences during the platform-building phase as the stock moves in a fairly tight sideways trading range or consolidation pattern. Breakout trading systems take advantage of these patterns by entering during the platform-building phase and then riding the sudden surge of price action as the stock moves up. Breakout trading systems are designed to find patterns in charts prior to breakout moves. The advantage is that breakout systems do not demand as much price movement as trending systems, so the market can be insipid and weak and these systems will still work well.
Market action can be very choppy and sideways. But the trader can hold as long as necessary for the next platform or consolidation to complete, anticipating another move up. It is common for stocks to gap up when the market is value-based. Understanding gaps, how they work, and where they form, is critical to success with any breakout trading system. Gaps can reap significant profits for the trader who knows how to use a breakout system in the right market conditions. The downside to breakout trading systems and strategies is they do not perform well during strongly trending markets because platforms and consolidations do not form during these periods of market momentum. By the very nature of the sideways or consolidation patterns, stops must be placed further below the entry than when using a trending system. This is because of the way that price moves up and down for a period before moving up in sideways markets. So points at risk are higher early on in the trade. However, the breakout system support level for the stop loss is much stronger and less likely to be whipsawed out whereas a trending system is going to experience whipsaws frequently in sideways markets.
Breakout systems are ideal for a market that builds platforms and they often provide a much higher profit return over a longer holding period. Breakout systems are commonly used for position trades or intermediate-term trades. This makes breakout systems ideal for busy people who want to trade but do not have time to study charts every day.
In our modern market, breakout systems work about 40-50% of the time. Hedging Systems Hedging systems became popular during the later part of the 20 th century, after institutions were allowed to trade the market. The original intent of the hedging system was to provide protection for the institutional portfolio during market correction phases. The institution would be holding stocks required by their charter and would be unable to sell them all during market corrections. The hedging systems allowed them to sell short certain stocks or derivatives to offset their losses. They became even more popular after the passage of the Roth IRA bill when a little-known rider eliminated the Rule of 3. Institutional traders started trading the market aggressively on a short-term basis, changing the dynamics of the marketplace forever. Hedging systems that are popular with retail traders are the spreading or straddle strategies of options. Many options players use spreads or straddles to attempt to offset a potential loss by having both a buy and a sell call or put in the same stock at the same time. Another use of hedging systems, by the more sophisticated trader, is to buy one market asset and sell another different market asset. Examples: futures traders who buy hogs and sell corn, currency traders who sell one currency and buy a different currency, or institutional investors who hedge indexes to protect their long term portfolios.
Hedging systems are usually complicated and require more skill than other trading systems. Traders who have a thorough background in not only trading stocks but also in other markets, such as bonds and commodities, have a better success rate than traders who only know a few options strategies.
Professional traders use hedging systems during periods when the market is in a short-term or intermediate-term correction. Therefore, hedging systems are used about 20% of the time. Unfortunately, most novice traders use hedging systems to attempt to mitigate losses. Hedging systems are not for beginners. The downside to using hedging systems for inexperienced traders is that they are trying to reduce losses caused by poor technical skills or a lack of market knowledge. Without proper technical skills and market education, hedging can increase rather than decrease a loss. Novice traders have a dismal success rate using hedging systems. Trading Range Systems Trading range systems were developed in the later part of the 20th century during periods when the market traded in a wide trading range for many years. Trading range systems were popular during the 70s and 80s. A trading range market lacks a dominant industry and often occurs during a period of economic stagnation. It is common for trading range markets to form after a huge speculative market has collapsed. Industry must reinvent and sometimes there is an absence of new technology to drive the market forward. The market shifts into a trading range based on weaker economic and business patterns. Certain sectors will dominate for brief periods and then fade as revenues falter. This creates an easily identifiable pattern for technical analysts to track. A trading range has a relative high and low price range. Most trading range systems require a minimum of a 10-point trading range for a stock or index. Not to be confused with the more common sideways pattern used for the breakout systems, a Trading range system is a wide loping price pattern that moves up to an approximate high and down to an approximate low price several times before breaking out up or down. Trading range systems take advantage of the cycling pattern of the trading range market. As a stock turns and begins to move up, an entry is triggered and the stock is held until the high price trigger is reached. Then, the trade becomes a sell short and the stock is held as it moves down. The benefits of a trading range system are that it allows you to buy as a stock is moving up and sell short as a stock is moving down. This allows the trader to be in the market most of the time.
During trading range markets, these systems are ideal and provide good profits for experienced traders. The downside to trading range systems is that the market doesn’t form these wide trading ranges except during certain economic and business periods. More importantly, though, the price range is never precise. The highs and lows of the range are approximate and price often turns above and below previous highs and lows. In addition, the stock or index can break out of that trading range and continue to move up or down with tremendous velocity from the initial move out of the lows without much warning. Traders who enter assuming the stock is going to continue to cycle can be in a losing trade that moves significantly against them. Therefore, trading range systems are more suited to traders with plenty of market experience.
Trading range systems work about 20-25% of the time. Counter-trend Systems Counter-trend systems trade against the primary trend of the market. A primary trend is the long term trend of the stock market, index, or stock. To determine the primary trend, use a weekly chart rather than a daily chart. Counter-trend systems are used in the contrary options strategies. Counter-trend systems have been used for many decades but have not been popular with retail traders due to the opposing nature of the trade.
Counter-trend traders are trading against the primary trend during a short-term or intermediate-term correction OR during a bounce or bear rally in a primary bear or downtrending market. Essentially, the trading requires taking a contrarian position in an overbought or oversold stock, index, or market. Counter-trend trading systems are usually highly sophisticated and require years of market experience. Swing traders, intra-day traders, day traders, and sell shorters typically use these systems. Knowledge of contrarian indicators is critical for success with counter-trend systems as is exceptional charting and technical analysis skills. A counter-trend trader must be able to anticipate a major market trend shift prior to the event. The risk is higher than trending or breakout systems due to the contrarian posture and the higher risk of trading against the primary trend even though stop losses are the same as for the trending systems.
Traders who use counter-trend systems must be experts at using stop losses. This is because the primary trend of the market is always dominant. Therefore, a return to the primary trend can occur suddenly and spectacularly. In such instances, stop losses may not trigger. For instance, when a downtrending market finds a bottom, it often climbs out of that bottom with a sudden vertical rise that can gap or run with velocity.
Counter-trend systems work about 20% of the time. They fail during trading range, sideways and consolidating markets. Summary: You must always consider the current market conditions under which you will apply the trading system. If you attempt to use a Trending System during a Platform-building market condition, you will have dismal results. If you attempt to apply a Trading Range System in a Velocity market, you will lose most of the profit potential. Here is a simple Checklist for making sure you’re using the right system for the right market condition:
Identify the Current Market Condition Select the Appropriate Trading System for that Market Condition Choose the Trading Style that fits that Market Condition Choose a Strategy that was designed to be used with that Trading Style
…and always trade wisely.
Martha Stokes, CMT Member of the Market Technicians Association Master Rated Technical Analyst: Decisions Unlimited, Inc. Instructor and Developer of TechniTrader® Stock Market Courses www.technitrader.com 888-846-5577
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