Six Market Types
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The six market conditions Dr. Tharp defined are based on both direction and volatility as follows:
- Bull, volatile
- Bull, quiet
- Sideways, volatile
- Sideways, quiet
- Bear, volatile
- Bear, quiet
The definition of these six conditions works well for classifying all types of trading in all time frames. The key benefit to classifying and identifying market type is that it helps traders evaluate more clearly how well a system will perform in each kind of market. This allows them to develop filters based on their classifications so that they are not trading a system when the market conditions are not right for it. Dr. Tharp explains “it’s pretty easy to design a quality system for any single market type. What’s difficult is trying to make it work in all types of markets.”
Some traders try to improve their systems continually, not realizing that they already have a good system that only works in certain kinds of markets. Instead of constantly trying to improve their system to work in all markets, they need to:
1) Develop filters to know what sort of market they are in.
2) Develop different systems that work better in the types of markets in which your original system is not effective.
When you develop and apply different systems for different market types, you’ll find that your total performance improves dramatically.[/vc_column_text][vc_separator el_width=”50″][vc_custom_heading text=”Filters” use_theme_fonts=”yes”][vc_column_text]The filters you develop should delineate which conditions are most prevalent in the market. These filters can be based on simple things like moving averages, bands, or channels, or more complex constructs such as time cycles, waves or inter-market studies. Whatever filters you choose, it should help you easily determine how to modify your system, or which system you should employ.
If you filter based on conditions that your system measures, then it improves your ability to anticipate how your system might perform. For example, suppose that your system relied on Wave classifications of some kind. Suppose further that you noticed bearish waves were shorter constructs than bullish waves. Such a filter might make you want to use a system that favored trades of a shorter duration during bearish waves compared to the duration of bullish waves.[/vc_column_text][vc_separator el_width=”50″][vc_custom_heading text=”Applying Market Types” use_theme_fonts=”yes”][vc_column_text]If you used Dr. Tharp’s six market types, you might find a way to improve your trading. For example, if your system is based on trend following, you already know (or will soon come to learn) that the primary weakness of such a system is its vulnerability to whipsaw trades. Whipsaw trades are short-duration losses that occur when a trending trade fails to materialize, and markets that change from bullish to sideways directions are infamous for producing a string of whipsaw trades. But a change in volatility can produce the same outcome. Either can create prolonged losing streaks.
Whipsaw trades cannot be fully eliminated among trend following systems, but their effect can be greatly reduced by simply eliminating some of the trading signals you follow any time the market changes from one type to another. Even a small reduction of whipsaw trades can have a profound impact on the overall performance of a trend-following system.[/vc_column_text][/vc_column][vc_column width=”1/4″][vc_widget_sidebar sidebar_id=”flash_right_sidebar”][/vc_column][/vc_row]