Wednesday, April 21, 2010

Keep an eye on the market state

There are basically four types of market state - it is either trending or non-trending, quiet or volatile. Trend followers love quiet trending markets. In these markets oscillators are useless. On the other hand, non-trending, volatile markets are ideal for those who like to trade counter-trend, either using oscillators and/or support and resistance levels. They are a nightmare for trend followers, as the whipsaws can easily erode capital. It is important to marry your own trading style or method to the state of the market, or to recognise when the market state does not fit your method, and stay out of the market. Quite a few traders have more than one system they use, and decide which one to use based on the state of the market.

When selecting stocks to trade, I use a volatility filter incorporated into my scans. I want to enter trades breaking out that are not too volatile. This is because a) volatility tends to increase when a breakout occurs and b) Selecting stocks that are not too volatile means that, in theory, your intial stop (by whatever method you choose) would be closer, meaning you can take a bigger position for the same amount of risk.

In addition, as I am a trend follower, the ideal state of the market for me is a quiet, trending market.

Here is a daily chart of the SPX:

Now, looking at this objectively, all I can see since the beginning of March is that:

1) Price has been moving up;
2) Volatility has been low.

This therefore satisfies my criteria for a quiet, trending market - the last few weeks have therefore been ideal for me to be looking for trading stocks on the long side that meet my criteria. The market has also been a drain on your capital if you've been trying to pick the top of the market.

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