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Feature

Understanding Market Type

by
Van K. Tharp
�

When you have a trading system, you should always know how it performs under various market conditions.  For me, there are six market conditions:

1.      Bull, volatile (Up, volatile)

2.      Bull, quiet (Up, quiet)

3.      Sideways, volatile

4.      Sideways, quiet

5.      Bear, volatile (Down, volatile)

6.      Bear, quiet (Down, quiet)

These six conditions work quite well for all types of trading and all time frames.  You could have nine conditions if you decided to have volatile, normal and quiet, which my friend Ken Long does.  However, about 60% of the market is sideways and it would be the same for �normal volatility� and I�d prefer to just have six market conditions.

It is crucial that you understand how your system will perform in each kind of market and develop filters so that you are not trading a system when the market is not right for it. 

The best way to do such an evaluation is to calculate your system�s System Quality Number (SQN)� for each market type.  (System Quality Numbers�  are discussed extensively in the Definitive Guide to Position Sizing, which will be available soon, and in many of our workshops.)  Generally, the better the SQN�, the easier it is to use position sizing� to meet your objectives.  In addition, systems probably should not be traded when the SQN� is below 1.6.

For example, suppose that you have at least 30 R-multiples from real trading for each of the six market types.  You calculate System Quality Numbers� and find the following information. 

Now, based upon the table, what can you say about your system?  First, you know that you have a trend following system that generally only works in trending (up or down) markets.  It doesn�t work in sideways markets.  Second, you can see that your system performs better in up markets than in down markets.  And lastly, it performs better in quiet markets than in volatile markets. Generally, if you avoid sideways markets, you will probably do fairly well with this system.

Some people are continually trying to improve their systems, not realizing that they already have a good system that only works in certain kinds of markets. As a result, instead of trying to constantly improve their system to work in all markets, they need to 1)  develop filters to know what sort of market we have (as we have done); and 2) develop different systems that work better in the types of markets in which your original system is not effective.  When you do that, you�ll find that your total performance improves dramatically.  It is a very simple step that could make you millions in the markets.

I�ll now be reporting market type regularly in my monthly update of the markets.  In fact, this market type filter will replace the 1-2-3 model because I believe it is much more useful.  The 1-2-3 model, in my opinion, will soon fail because the valuation portion of it will start signaling �buy� even though we are in a secular bear market in which valuation (i.e., PE ratios) could go down to the single digit range.

So how do we measure market type?  I will be using the S&P 500 index to measure the market type for the  U.S. stock market.  My reporting will only be applicable to the  U.S. stock market, and not to futures markets, forex, or foreign equity markets.  Those markets would require using a different index.  However, I�ll describe how our filter was developed and then you can use the same principle to develop market type measurements for the markets that you like to trade.

Over the last 30 years, the absolute value of the weekly change for the S&P 500 has averaged 1.60851%.  In fact, when I compared the last 15 years with the last 30 years, both measures were about 1.6%.  Thus, if the absolute value of last week�s change is above 1.60851%, then it is considered a volatile market.  If the absolute value of last week�s change is below 1.60851%, then it is considered a quiet market.  And as the absolute value of the average weekly change adjusts over time, we use the new adjusted value.

Next, to determine market direction, we look at the amount of change over the last 13 weeks.  This amounts to a moving 13 week window, so we will have a market type for each week.  Over the last 30 years, the absolute value of the 13 week change has been 5.63793%.  When we look at the 13 week change, we first ask the question: �Is it between -5.63793% and +5.63793%?�  If it is between those two values, then the market is considered to be sideways.  If the market change over the last 13 weeks is greater than 5.63793%, then it is considered to be an up market.  And if the market change over the last 13 weeks is down more than -5.63793%, then the market is considered to be down.  This value makes about 60% of the market types as being sideways.

Thus, on a weekly basis I can classify the market type and I will be reporting these to you on a 13 week basis each month when I do my monthly update.  Look for the first one next week.

The next table presents summary data of the market type for the last 30 years.

You�ll notice that only about 11% of the 13 week moving windows are classified as bear.  However, the 30 year period includes 18 years of secular bull market (1982-2000) and only 12 years of secular bear market (i.e., 1978-1982, and 2000-2008).  For example, the next table shows the percentages for the last year.  Notice that the last year has been volatile 65% of the time (vs. 33% for the 30 year period) and down 23% of the time (vs. 11% for the 30 year period). 

I also plan to look at streaks within market type.  In other words, how long does a market type continue.  As an illustration of what to expect, the next table shows the weekly market type classification for 2007.  Notice that we had a five week quiet bull trend plus one other volatile bull week that was probably not enough to really say that market type had changed.  We only had one bear week, which led into 2008.  And since 23% of the last 52 weeks have been classified as down, you can see that 2008 has been an entirely different market, which we�ll discuss next week.

You�ll also notice that the second half of 2007 was largely volatile, while the first half of the year was largely quiet.  This is valuable information to know when you are assessing your system performance for 2007.

Market type streaks tend to last four weeks or longer.  This suggests that it might not be prudent to consider that the market type has changed until we see at least two consecutive weeks of the same type. 

In the future I plan to do a lot more research on market type.  We�ll be looking at trends in market type, how long the various types tend to last, and market type for day traders.  I�ll either report this information briefly in Tharp�s Thoughts or more extensively in a special report if there is enough interest in such a report.  Next week, look for our first inclusion of market type in our monthly update of the market.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

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Trading Tip

The Nobel Laureate and the Rice Trader � 
Psychology�s Role in Trading Strategies Part III

by
D.R. Barton

�Success is the ability to go from one failure to another with no loss of enthusiasm.�  --Winston Churchill

I�m constantly amazed by the quality of folks that read and comment on the articles here (insert collective sigh for excessive pandering to the readers).

And last week I heard from many of you that had similar thoughts � that sometimes taking the certain gain makes more sense, especially if it is a one time deal.  All of which leads right into today�s article!

If any of your have read Safe Strategies for Financial Freedom, the book that Van and I wrote with our good friend Steve Sjuggerud, you may recall that in Chapter 13, I couched all of the expectancy question in terms of decisions made over multiple trials.

Most of the e-mails centered on that theme � decision making changes if it is a one time vs. a multiple event scenario.  (And thanks to all of you who sent in your thoughts!)

But here�s the challenge for that thought.  Here�s the thought process:  If taking a sure $450 instead of a 50% to get $1,000 and a 50% chance to get $0 is reasonable, then how about taking a sure $100 (or $10 for that matter) instead of a 50% to get $1,000 and a 50% chance to get $0?

The key is, when do you draw the line?  What process do you use to say that a sure $75 is too little, but anything above a sure $423.77 will suffice?  In general, folks make those decisions based on the wrong rule set.

Basically, Kahneman�s work says that our rule of thumb in this regard is very weak.

Yes, our personal situation matters if it�s a one-time deal.  Yes,  the frequency of opportunity is important as well.

But a bigger point that is huge for most people leaps out.  Dealing with Kahneman's ideas of prospect theory brings us back to on of the biggest problems that all traders and investors face � we have a strong tendency to make any one trade matter too much (and it�s always the current one that we�re managing!).

This was one of the major points that William Eckhardt made in the book The New Market Wizards.  When one trade matters too much, we tend to revert to our poor performing heuristics (rules of thumb) and become more risk seeking when a trade is a loser and more risk averse when a trade is a winner.

What can we do to avoid this trap of reverting to poor decision-making in the moment?  First of all, trade and invest according to a plan.  If you follow your plan or guidelines while in a trade, you are much less likely to let emotions and faulty �rules of thumb� take over.  Here are a few more concepts that can help:

�  Adopt an attitude of indifference to losses.  Consider losses a business expense.  Better yet, frame your losses as the necessary �raw materials� for your business.  Framing losses this ways has several clear benefits.  You understand that losses are a required part of trading.  You want to minimize the cost of raw materials, not avoid them! (If you never bought any raw materials, you could never make any products�)

�  Accept uncertainty as a part of trading.  The 2002 Nobel winner found that people pay too much to avoid uncertainty.  There are many areas in life where people accept uncertainty: relationships are almost always uncertain, so are fishing trips and cheering for the Chicago Cubs.  In any of these endeavors, we don�t know how they will end (okay � except for the Cubs.  We know how THAT will turn out�).  It�s the same with our trading.  Accept that any single trade could be a win or a loss.  Get out if your wrong, and hang on if you�re right.  Over a large number of trades, good traders and good trading strategies will win.  But for one trade, anything can happen.  So don�t get emotionally attached to a trade.  Execute your plan and move on to the next opportunity.

�  Understand the Law of Small Numbers.  Traders, like golfers, seem to be eternal optimists.  A golfer can take 100 bad swings and still be excited to go out and play tomorrow because of one good shot.  In a similar way, traders often draw broad conclusions from a ridiculously small number of data points.  I wish I had a buck for every time I�ve heard, �That system (or newsletter or strategy) stinks � it lost three times in a row!�   Then the optimist thought process kicks in, �There has to be something better out there!�  Realize that it is impossible to draw a meaningful conclusion from a small number of data points. Three, four or even ten occurrences are not enough to draw a conclusion in the trading world (or in any complex environment).  Spend the time to understand why your trading or investing strategy works and don�t throw it away after a few losses.  In terms of statistics, 30 trials is usually a bare minimum number that is needed to make any meaningful decisions.

So many good questions keep popping up that our limited space has made us delay talking about our famous rice trader and his unique blend of psychology, technical and fundamental analysis.  But our patience will pay off!

Until next week�

Great Trading!

D. R.

About D.R. Barton:  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 �iitm.com�. 

Melita's Inspirational Corner

Unfinished Projects

by
Melita Hunt

I have been meaning to get back into my writing for the last few weeks, but just haven�t had the inclination, the desire or the energy to do it. Previously, I would have forced myself to do it anyway, convinced that I �had to get it done.� That it was my duty and obligation. 

I�ve now realized that the important thing isn�t just writing for the sake of it. It is writing because I truly want to, or because I have something valuable or inspirational to share with our readers.

Over the last few weeks I have been through many trials and tribulations adjusting to my new treatment program and the current circumstances that I have found myself in. And I have been growing exponentially as a person in the process. There have been many profound lessons learned. When I finally have the energy and desire to share these learning�s, then I certainly will.  But right now I am smack bang in the middle of them and just need to keep things light and breezy. 

So for the time being, I ask that you bear with me as I just share passages and texts with you from the plethora of books and readings that I am enjoying each day, in the hope that something might also touch a cord within you. The following is from the Journey to the Heart Daily Meditation Book by Melody Beattie. It is especially poignant for me right now because I feel that I am living with so many things left �undone.� I have emails, magazines, letters that are piling up, a whole load of unpacking to do, taxes and paperwork that always seem to need my attention, and the inevitable list of goals: books to write, photos to organize, projects to complete and ideas to bring to fruition. 

The truth is that they may never get done! So here is what Melody had to say about that: 

Whether the project is sewing a dress, reading a book, writing a book, building a home, or learning a lesson, learn to live comfortably with unfinished work. Whatever you are working on, whatever you are in the midst of doesn�t need to be finished in perfect order, with all of the loose ends in place for you to be happy. 

For too many years, we worried and fretted, denying ourselves happiness until we could see the whole picture, learn the entire lesson, cross every t and dot each i. That meant we spent a lot of stressful time waiting for that one moment when the project was complete. 

Enjoy all of the stages of the process you are in. The first moments when the germ of the idea finds you. The time before you begin, when the seed lies dormant in the ground, getting ready to grow. The beginning, and all the days throughout the middle. Those bleak days, when it looks like you�re stuck and won�t break through. Those exciting days, when the project, the lesson, the life you are building takes shape and form. 

Be happy now. Enjoy the creative process � the process of creating your life, yourself and the project you are working on � today. Don�t wait for those finishing moments to take pleasure in your work and your life. Find joy all along the way. 

Melita Hunt is the CEO of the Van Tharp Institute. If you would like to keep up with Melita�s progress regarding her recently diagnosed lung cancer (she is a never-smoker). Please feel free to read her blog at www.myleftlung.com. You can contact Melita at [email protected]

 

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