Saturday, April 19, 2014

When market conditions change

There are four basic market states - trending or non-trending, stable or volatile. Different trading methodologies are designed to profit from whatever combination of market conditions are out there. Trend followers find stable trending conditions the most favourable. Shorter term traders, swing traders or day traders prefer non-trending, volatile conditions.

These different phases are all part of the ebb and flow of the markets. Learning how to identify and interpret the prevailing market conditions is a key component in achieving trading success, regardless of your own preferred method of trading.

For a trend follower, this would mean stepping up your trading activity and overall risk exposure when a new general market trend has been identified, or tapering off when market direction becomes less clear. Volatility in the indices tends to increase when the trend is trying to reverse.

"Three out of four stocks will go in the same direction as a significant move in the market averages." - William O'Neill, from his Market Wizards interview.

On that basis, it stands to reason that when the market averages are trending, then your odds increase of trading an individual stock successfully in the same direction. When there is no direction, those odds would be reduced.

I have referred several times here to 2011 as being a difficult year for trend following and my own approach. For the most part, the prevailing conditions were volatile and non-trending - exactly the worst combination for a trend follower. I am seeing a similar trading environment so far in 2014.

While this can be frustrating, learning the patience and discipline to wait for more favourable conditions is all part of a traders' education.

And, as sure as night follows day, a period where the markets are not trending will be followed by a period where they do. And that will provide trend followers with an opportunity.

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