TRADING TECHNIQUES
See The Market According To You
Understanding Market Structure
by Paolo Pezzutti
Understanding the market before placing your trade can make a huge difference to your trading performance.Different financial markets have different behaviors. This is because of the intrinsic characteristics of these markets (growth/value stock, for example), market liquidity, participants (long-/short-term investors, institutions, daytraders, and position traders), and factors that affect the markets when market players elaborate information. You can make your system/method work under the technical conditions that best fit the logic of the market if you understand the market structure. Ideally, you want to let your system/family of systems work only in environments that maximize their performance. For example, running a short-term system on a market with a low daily range would probably not be profitable after commissions and slippage.
THE STATES OF THE MARKET
The first step is to identify the state of the market so that you trade only when specific conditions are met. You can do that by applying a filter, but before you do so, let's try to conceptualize the subject. The main components of price movement are directionality and volatility. Volatility can be defined as a measure of an asset's tendency to move up and down in price over the latest n periods. Directionality can be defined as a measure of an asset's tendency to move along a defined trend. By combining these elements, you can come up with four market states:
• High directionality - low volatility: As you can see in Figure 1, the trend is well defined and strong. Prices move steadily up/down with no or little reaction or correction. In such a scenario, trend-following systems work fine, but you should avoid countertrend tactics. In this scenario, oscillators will continuously give false signals. Typically, the public does not participate much because they haven't noticed the trend.• High directionality - high volatility: The trend is well defined (see Figure 2), and corrections are deep and volatile. You'll see a lot more public participation. This scenario favors swing traders. Trend-followers will risk being stopped out during reactions.
...Continued in the March issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the March 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2006, Technical Analysis, Inc.
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