Editor’s Note: Dr. Van Tharp’s content is timeless and our goal for the future is to continue to share his material with our readers as written by him. Today’s tip is an excerpt from a past article, “How to Design a Trading System to Trade a Particular Market Type”.
System design and development become easier and more effective when you think about how prices behave in each market type. Let’s assume that what works in a bull market will also apply to a strong bull market and the same for bear and strong bear. Then, let’s approach designing two systems—one for a bull quiet market and a second for a bear volatile market.
First, let’s think about a bull quiet market. In this type of market, everyone thinks they are a stock market genius because buy and hold actually works. If you want to go the “buy and hold” route, it might be better to set a stop wide enough to stay outside of the normal trading noise, but narrow enough so that if the market changed, you’d be able to get out. Our research suggests that a 25% trailing stop usually works well enough for this purpose.
A simple system for a bull quiet market in an equities market would filter for buying the following:
- Highly efficient stocks
- Stocks with high SQN® (System Quality Number®) scores
- The strongest stocks in the strongest sectors of the markets
You’d then need a specific entry:
- Buy after a retracement
- Buy after a breakout on a consolidation
You’d need to determine when you might be wrong about the trade to set up your initial risk:
- When it goes down below the old low of the retracement
- When it goes back into the baseline consolidation area
And you’d need to have a fairly good idea that your potential reward was two to three times your risk. Your exit method determines your reward. Here are a few that might work:
- A trailing stop
- A market type change exit
- Exiting a poorly performing position when you find a much better candidate
Determining the SQN score for your system allows you to develop a Position Sizing™ strategy to meet your objectives. (We go into this critical aspect of trading a great deal at the How to Develop Winning Trading Systems That Fit You Workshop.)
Contrast the conditions of a bull quiet market with a bear volatile market where you have to deal with large price swings—mostly going down. Could the strategy presented work “in reverse” on the short side? Probably not for many reasons:
- Wide stops limit potential reward on the downside. For example, a 25% trailing stop on a short position would give you a maximum reward of only 4R win (i.e., if the company went bankrupt and the stock went to zero).
- Wide stops can be breached simply because of the inherent high volatility of bear markets.
- Bear markets do everything they can to psychologically press your buttons.
If and when you understand these aspects of bear volatile markets, however, you can design good systems that work well in those conditions.
If you would like to start designing those systems with us, we invite you to register for How to Develop Winning Trading Systems That Fit You, starting on May 25th, 2022!