“It’s insane to expect that same system to work well in all market types.” – Van Tharp, Market Wizard
Perhaps the biggest mistake that traders make when they build their Forex trading system has to do with market types. Traders tend to put blinkers on and use the same approach, no matter what the market is doing in front of them. But it is very difficult to have a winning trading system that works well in all conditions.
Your system might work well in trending markets, and perform poorly in sideways markets – so why trade it in sideways markets?
The simple solution is to identify the market type first, and then apply a strategy that works in that market type.
Primary Market Types
“Successful traders adapt to changing market conditions” – Jack Schwager discussing insights from Edward Thorp, Market Wizard
Van Tharp, a market wizard and expert on market types, suggests that there are as many as 26 market types. You will see this too, as you get more experienced in identifying them.
Sometimes it’s difficult to work out an exact classification for the market type at all, but don’t let that set you back – close enough is good enough.
For our Forex trading, we tend to use six primary market types:
- Bull normal
- Bull volatile
- Bear normal
- Bear volatile
- Sideways quiet
- Sideways volatile
There are several methods of identifying market types. Van Tharp uses a mechanical market type classification system that applies an algorithm to market direction and volatility. I prefer to use charts when trading Forex (more on this below).
You can see the primary market types here on the weekly chart of the JPY/USD:
Now your turn. How many market types can you spot on this chart?
Here is what I can find:
Can you see how it would be difficult to trade the same way in all these market types?
Shifting market types: trading transitions
Like the sea turns from calm to stormy, so do the markets.
One of the tricks to using market types is knowing what to expect next. Trading is very much about probabilities, and if you know which market type(s) will likely follow next, then it can give you a big edge.
Here are the primary market types, and an indication of what often comes next:
- Bull normal. Followed by a bull volatile or sideways quiet.
- Bull volatile. Followed by a sideways volatile or a bear volatile
- Bear normal. Followed by a bear volatile or a sideways quiet
- Bear volatile. Followed by a bull volatile or a sideways volatile
- Sideways quiet. Followed by a bull or bear normal, or a sideways volatile
- Sideways volatile. Followed by a bull or bear normal or a sideways quiet.
So if you are in a bull normal market, you can expect a bull volatile to happen next, and then you can be wary in a bull volatile that it could quickly drop into a bear volatile, and you can plan appropriately.
Position sizing in different market types
“Traders…need to adjust position size in response to the changing market environment” – Jack Schwager, discussing insights from Steve Clark, Market Wizard
Market types play an important part in your position-sizing.
You may not necessarily need to stop trading a strategy in a market type that it does not work so well in. Rather, you can simply reduce the position size. Similarly, if you have a strategy that works very well in a certain market type, you could then trade much bigger sizes when in that market type.
An easy to use technique for identifying market types
To identify market types in Forex, I use the Bollinger Bands.
Depending on the type of trade you are looking to place, you would use these tools on the weekly or daily 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 to identify market types.
You will want to use either the 10 period or the 20 period Bollinger bands. Both work, but have a different degree of sensitivity. As a “rules based” discretionary trader, don’t be afraid to play around with the indicator until it gives you the insight you are after.
When the Bollinger Bands are expanded slightly, it is a sign of a normally trending market type. When they are stretched, it is a sign of a volatile market type. When they are contracted, it is a sign of a quiet market type.
If the price is trending in the direction of the upper or lower Bollinger bands, then that will indicate a bull or bear market. If the price is between the two bands without clear direction, the market type is sideways.
If you combine these two factors, you can normally identify the market type pretty easily.
While Bollinger Bands are very useful, market type identification can be improved by using price action.
Picking the market type with price action
Price action will allow you to identify bull volatile or bear volatile market types better than the Bollinger Bands, and it can also help you to get in on market type transitions early.
Bull volatile and bear volatile markets can be identified simply by increasingly long candles or bars.
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 the market type will often change direction when it hits a significant support and resistance level.
You can look for candlestick reversals off weekly support and resistance levels, or double tops and bottoms, for a sign of the change in market type direction. Go down to the daily chart to look for these reversals, if you want to be more aggressive.
Just be very aware of what is going on, as reversals don’t always work out and the original direction could resume with a vengeance!
Strategies for different market types
“When you have a trading system, you should always know how it performs under various market conditions.” – Van Tharp, Market Wizard
Van Tharp believes that it’s nigh on impossible to build a Holy Grail system that works in all market types, but it’s not that difficult to build one that works well in a particular market type.
His suggestion is that traders develop a number of non-correlated systems that work well in different market types. This is generally a good idea, as it will help improve your consistency.
Let’s take a brief look at each market type and a strategy that you can apply in each one.
To identify a bull normal market type, look for the price to be trending with the upper band, and above the mid Bollinger band.
Generally, bull normal market types suit trend following strategies. Look for a pullback or a consolidation phase and breakout to buy the direction of the trend.
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 is the opposite of bull normal. The price trends with the lower bands, and remains below the mid band.
Like the bull normal, look for pullbacks to key levels, and consolidation phases with a breakout in the direction of the trend.
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 with tight stops and let profits run.
In a sideways volatile market type, the bands are wide and there is large sideways price movement.
Sideways volatile markets suit a band trading approach. Look for prices to get to the edge of the band and fade the move back towards the opposite edge of the band.
In a sideways quiet market type, the bands contract and the price forms a tight range.
Many traders find sideways quiet market types difficult, but they can be very lucrative if you are patient enough to wait for the breakout. Alternatively, you could go down to a lower timeframe and apply a band trading approach.
Advanced market types
Since the original version of the lesson was posted we have extended our work with some advanced market type classifications. You can read about them here.
Trade in the moment with market types
“It’s easy to design a good system that works well in any one market type” – Van Tharp, Market Wizard
Instead of focusing your time on trying to find a unicorn – the trading strategy that works in every market type – build a system for identifying the market type, and apply a simple low risk/high reward trading strategy that fits.
Building a winning Forex trading system does not have to be difficult, but it will be if you don’t use market types.
Take some time now to add the Bollinger Bands to your favourite currency pairs, and identify the market type you are in right now.
Are you trading the right or the wrong strategy for the market type?
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Until next week,
- Complete the Market Types course work.