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.
