Tharp's Thoughts Weekly Newsletter (View On-Line)

• Article Market Types for Forex by Sam Eder
• Workshops Forex and Bear Market Workshops Just Added for May 2015
• Trading Tip My Favorite Trading Books to Give by D. R. Barton, Jr.
• Matrix Contest A Eureka Moment by Callum M.

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Article

Market Types for Forex

by Sam Eder

Perhaps the biggest mistake that many traders make is ignoring market types when they build their trading systems. Most traders tend to put blinkers on and try to use the same strategy no matter what the market is doing in-front of them. But having a trading system that works well in all conditions is difficult – if not impossible. 

Your system might work well in trending markets and perform poorly in sideways markets.  So why trade it in sideways markets? The simplest solution?  Identify the market type, and then apply a strategy that works in that market type.

Identifying Market Types in Forex

There are several methods of identifying market types. Van Tharp uses a mechanical market type classification system that applies an algorithm for market direction and volatility. For my Forex trading, I prefer to use charts for their simplicity and ease of access. I have a simple framework and on the chart below, you can see quite easily multiple market types using weekly bars for the JPY/USD pair.

(Click on any of the charts in this article to see a larger version)

To identify market types in Forex, I use Bollinger Bands. Depending on the type of trade you are looking to place, you could use Bollinger Bands on the weekly, daily or even 4 hour charts. I tend to use the weekly chart to identify the market type, though I stalk entries off the hourly chart. The shorter your trading horizon, the lower the timeframe you will use. 

The Bollinger Bands can be set to either 10 periods or the more common 20 periods. Both work, but have a different degree of sensitivity. If you are a “rules based” discretionary trader, don’t be afraid to play around with the indicator until it gives you the insight you desire.  When I am trading, I often switch settings and timeframes depending on what I am trying to determine and achieve. Sometimes, mysteries on the weekly chart become very clear after looking at the 4 hour chart.

The width of Bollinger Bands can help you determine the relative volatility.  When Bollinger Bands expand gradually, it is a sign of a normally trending market type. When they stretch out quickly, it is a sign of a volatile market type.  When they contract, that’s a quiet market type. See the chart below for examples of each —

How the price bars interact with the bands helps you determine the trending portion of market type.  If price seems to “push” the upper Bollinger Band up or the lower band down, that indicates a trending bull or bear market. If price bars generally stay between the two bands with no clear direction, the market type is sideways.

If you combine volatility with trend, you can generally identify the market type pretty easily.

While Bollinger Bands are very useful, market type identification can be improved by using price action.

Determining Market Type With Price Action

Price action allows you to identify bull volatile or bear volatile market types better than simply relying on Bollinger Bands.  Price action can also help you to identify market type transitions early on.

Bull volatile and bear volatile markets can be identified by increasingly long candles or bars.

Rather than an orderly transition, the switch from a bullish to bearish market type (and vice versa) can be quite rapid. Price action can be used to identify this switch, as often the market type will change direction when it hits a significant support and resistance level.  

For a sign of a market type direction change in the weekly price chart, look for candlestick reversals off of support and resistance levels or look for double tops and bottoms. Then, you can look for reversal setups in a more aggressive way by going down to the daily chart.

Just stay very aware of what is really going on. Reversals don’t always work out and sometimes the original direction can resume with a vengeance!

Strategies for different market types

Van Tharp believes that it’s nigh on impossible to build a Holy Grail system that works in all market types.  Instead of trying to build Holy Grail systems, Van recommends that traders develop a number of non-correlated systems that each work well in different market types. This is generally a good idea as it will help improve your performance consistency and it will also teach you to think flexibly.

Let’s take a brief look at each market type and a simple strategy that you might apply in each one.

Bull Normal

To identify a bull normal market type, look for the price to be trending with the upper band — above the mid Bollinger Band. Generally, bull normal market types suit trend-following strategies. Look for a pull-back or a consolidation phase and break-out to buy the direction of the trend. 

Bull Volatile

In a bull volatile market type, you will see long bullish bars or candles when the price trends with the upper band. The price may frequently cross above the upper band itself. Bull volatile market types can suit short-term swing trading strategies. Stops should be kept tight, and profits left to run for some strong risk/reward trades.

Bear Normal

Bear normal is the opposite of bull normal. The price trends with the lower bands and remains below the mid band. Like bull normal, look for pullbacks to key levels and consolidation phases with a break-out in the direction of the trend. 

Bear Volatile

Bear volatile is the opposite of bull volatile. You will see long bearish bars develop that sometimes cross below the lower band. As in the bull volatile, look for swing trading opportunities in the direction of the trend. Again, keep tight stops and let profits run.

Sideways Volatile

In a sideways volatile market type, the bands are wide and the price action includes large bars that just move sideways. Sideways volatile markets suit a band trading approach. Look for prices to get to the edge of the band, fade, then move back towards the opposite edge of the band.

Sideways Quiet

In a sideways quiet market type the bands contract and the price forms a tight range. Many traders find sideways quiet market types difficult to trade, but they can be very lucrative if you are patient enough to wait for the eventual break-out. Alternatively you could go down to a lower timeframe and apply a band trading approach. 

Trade What’s In Front Of You

Instead of focusing your time on hunting for a unicorn — a trading strategy that performs well in every market type — you could take a more practical approach:  create a method to identify market types and build a set of systems that apply simple low risk/high reward trading strategies to each market type.

About the Author: Based in Sydney, Sam Eder trades currencies using rule-based discretionary systems. He has studied Van Tharp’s trading principles extensively over the last 10 years and incorporates many of those when writing his daily blog posts on his Forex signals service FXRenew.

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Trading Tip

My Favorite Books to Give: For the Trader Who Has Everything

by D. R. Barton, Jr.

Traders can be a tough lot to please in the gift-giving department.  Here are a few book ideas for the trader on your list — or for your list if a loved one asks you what you might like. 

(Please note — discretion dictates that I do not include any of Van’s books in the list — including the three he and I have collaborated on — since I assume you’ve generously bought copies for everyone you know already…)

Of course you will probably have read or at least heard of most of these, but there may be a gem hidden here and there. Since everyone’s time is valuable, I’ve given you a synopsis of why I think the book would be worth your while.  For today’s article, I’m not trying to build a comprehensive list but instead trying to give a few titles that might be just a little outside the mainstream (except for the first two entries).

Obligatory Inclusions / Classics

Reminiscences of a Stock Operator by Edwin Lefèvre

It’s hard to keep this off of any list.  What?  You say you still haven’t read it?  Get the Kindle version for a buck ninety-nine!  At that price, download it onto your smart phone and start reading it the next time you’re stuck in the doctor’s office (it sure beats a tattered four month old People magazine). In addition to describing the allure of trading, Lefèvre’s book also captures the frenzy of market extremes so well that it could be recounting the Ebola low from just several weeks back.

Market Wizard and New Market Wizards by Jack Schwager

For a trader mindset and a don’t-give-up attitude, these first two Market Wizard books are hard to beat (check out how many of these folks had blown up or at least had serious trials by fire before finding their footing and becoming a “wizard”).  The strategies and market structure references for the traders profiled might not be so fresh anymore, but I still hear the voices of these traders echoing in my head.

A Nuts and Bolts Book that Is Off of Most People’s Radar  

Trading Systems and Methods by Perry J. Kaufman

Van recommended that I read Kaufman’s Smarter Trading (a good book in its own right) which then led me to his behemoth.  Encyclopedic in scope, it shows off Kaufman’s proclivity for depth in every subject covered.  It gives some sound thinking on system logic as he breaks down many “famous” and standard strategies (turtles, two & three MA crossovers, etc.).  This is not a front-to-back type of book to read, but one you’ll pull off the shelf time and again.  See how strongly buyers and sellers of this book value it by checking out the used book prices.

Two Books that Give Very Different High Level Views of Markets

Behavioral Finance by James Montier

This one is a bit pedantic, but has some very useful insights.  Chapter five covers covariance, correlation, return distributions and price action’s relation to Gaussian (normal) distributions and it fundamentally changed the way I look at markets.

Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein

Easily one of my favorite reads.  If you or someone you know likes the history of concepts (risk and uncertainty, in this case) then this book is a genuine treat.  Rather than a slog through a technical mire, this book is so well-written and has so many fascinating historical stories that it’s truly a joy to read.

This Year’s Hot Read

Capital in the Twenty-First Century by Thomas Piketty

Although this book had a much bigger buzz in the spring when it was released, it will certainly be a Christmas gift favorite this year — much like the Buffet biography The Snowball was back in 2009.  I would guess, however, that few readers will make it through all 696 pages.  If it turns out that understanding the intricacies of income inequality isn’t your thing, then this book might make an impressive (re)gift for someone else in 2015.

I’d love to hear some of your favorite trading books, either in the well-known realm or lesser known finds.  Send your thoughts and suggestions to drbarton “at” vantharp.com

Great trading and God bless you,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".

Disclaimer

Matrix Contest

A Eureka Moment

Dear Van,
 
I already read Trading Beyond the Matrix twice just to make sure I was reading it correctly. This third time I'm putting into practice the steps you have laid out. No wonder no one can Trade for the first year...it's hard work, emotionally, mentally even quite physically draining. I've got to admit, the first time I read the book I thought you'd gone a little to far, it actually felt uncomfortable to read. A few years ago I would have put the book down and never returned. But things have changed in me over the last couple of years and I decided to hear you out. A lot of the things you were saying I'd already done without realizing it was a path I was taking. Forgiving myself and others, a therapist told me that, and that little trick got me out of severe depression. Walk with your head high and shoulders back, it's amazing how much more confident you feel just by doing that. Whatever mood/feeling you wake up in, go to the mirror and put a smile on your face. It works. All this put me in good stead to listen to what you were saying without passing judgment on your mental capacity. Although it wasn't until I read the book the second time did I come to realize that I had actually done some of this stuff already, without really understanding what I had done and how much I had improved... 

Believing that something is possible, however, does not make it happen; why can't life be like a fairy tale? Even the first assignment had me scratching my head: list your parts. I came up with 20, after 4 days and nights, and a bit of exaggeration admittedly. Out of these 20, I believe now that only 4 of these may actually be my real parts. Don't get me wrong, I know I have more to find. But only 4 really gave me beliefs, lots of them, rapidly. The other parts I think are just what I think should be parts, I sort of wrote them down after looking at the examples. For some reason I think I should deal with these first four. It's like someone took my hand and starting writing and the horrible bugger didn't hold back. The one thing that struck me and also hurt a bit too, was the negativity, even about stuff I thought I was good at...Four parts each with well over twenty beliefs and I'd say at least 90% were negative. I tried to look at it objectively when doing the "what this gets you into and out of", but it meant nothing really. It didn't take a rocket scientist to work out that these beliefs were of no use to me. But how to change them? How to release them? These feelings weren't just charged, it was more like a lightning bolt. I struggled with this for a few days, then remembered one of your Super Traders saying he found feeling release easier with the Sedona Method. It seemed quite simple and after a bit of practice I managed to release some day to day feelings. Anxiety was the main culprit (nearly gone now).

As I progressed through the book, I found the section with the chart of the Nine Emotional States. Wow, it's one of those things I'd found earlier in life ( probably would have meant nothing to me had I actually found it years ago) a Eureka moment. I had managed by myself with no training to move from Apathy, through Grief and I wish I could say further, but I was still proud. I knew I wasn't happy, I've known (but not known) for years but looking at the charts I'm sort of stuck between fear, lust and greed. I decided it was time to tackle those beliefs again using the Sedona Method. Can I just suggest to you on a serious note that your book and the Sedona Method for that matter should come with a warning sticker...a big one. I know it is mentioned briefly in passing that it may take a while to release your first feeling and then an eruption may take place... Well for someone that has spent the last 35 years suppressing feelings, emotions, anything my Dad would consider girly. It hit me square in the face...hard...

I'm not going to lie, it scared the living daylights out of me. It put me back into Apathy for probably a week, Grief next, back to Apathy. Scary times. The return of the anxiety was the worst, my smile had all but gone. Then I had a stupid row with my extremely wonderful girlfriend over nothing, about nothing, solving nothing. So off to the beach we go, me on the back of the moped. Talking to myself as in "take myself outside and have a quiet word with myself". We have never had a crossed word before. This is making us miserable. This is just a feeling, I start to release...then panic hits me "What if I get another rush of feelings". "I can't handle that on my own". "If only I had an inner guidance".
Softly, my voice but not me, "You do".
 
Haven't got there again...yet. But you've opened the door and given me the map. Hopefully one day I can shake your hand and say "Thank You". I know there will be times ahead when I'm probably not going to like you much. But I feel I can handle the up's and down's much better...I know my end goal.
 
Callum M.

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