Talking Points –
- The future is unpredictable, but analysis can help traders get probabilities in their favor.
- Matching the appropriate strategy with the correct market condition can assist in this analysis.
- Below, we explain the three primary conditions and how traders can approach each.
As a large portion of the United States gets pummeled with record-breaking onslaughts of snow, it’s hard to remember that spring is right around-the-corner. Blankets of snow and sheets of ice get replaced by green shoots of grass and singing birds; welcoming a new and better time.
To those of you living in a comfortable year-round climate, wondering why someone might want to put up with such misery; well it’s because the cold of winter only makes the warmth of spring and summer that much better. ‘It’s just the seasons,’ as they say. It’s just a cycle; a pattern that nature has been working on for as long as people have roamed this earth.
Most living things have cycles. Markets have cycles too. And to the trader looking to make money in markets, the identification of such cycles is of the upmost importance.
Because if we wear our winter jackets, and gloves, and scarves in the middle of summer – well, we’re probably in for a pretty uncomfortable time.
And the same thing goes for right now: If I were to walk outside in a sleeveless t-shirt, shorts, and flip flops I’d likely catch hypothermia and be in for a very bad time, to say the least.
It’s the identification of these cycles and patterns that allow us to work with them. It’s just as Charles Darwin said: “It’s not the strongest, or the smartest of a species to survive. It’s those that are most wiling to adapt.”
If you want to survive as a trader, you have to learn how to adapt. In this article, we’re going to show you how to do that.
The Cycles of a Market
Most markets will exhibit one of three predominant market conditions. It doesn’t matter if you analyze a market fundamentally, or technically, or spiritually, or by consulting with the stars: Prices move in different types of patterns.
But traders don’t just want to identify these patterns; they want to use them. By identifying these patterns, or ‘states’ of a market; the trader can more eloquently decide how to trade in that particular environment.
The three major market conditions are trends, ranges, and breakouts; as shown below.
The Life Cycle of a Market
Created with Marketscope/Trading Station II; prepared by James Stanley
Once again, these conditions or states are often driven by fundamentals or news (or in the case of some ranges, a lack thereof). And once a trader identifies these conditions, they can employ the proper strategy to trade in that market.
The Trend is Your Friend
We talk about trends and trend-trading a lot at DailyFX. And there is a reason for it: The future is uncertain, and while identifying a market condition is of great help, it’s never going to work 100% of the time because things in the future change.
By identifying a trend, and noticing a bias that has existed in the market recently, we may be able to jump on that theme so that if it continues we might be able to see some profitable trades.
But trading a trend is a bit of a conundrum. See, it’s not enough to simply say ‘the trend is up so I’m just going to buy it.’ No, we want to enter in trends more efficiently than that. So, if I want to buy an up-trend, I really want to do so as cheaply as possible, which is he conundrum. I want to buy after price has come down.
When traders are speculating in a trend, they want to look to employ that age-old logic that we’ve been taught since we were all toddlers: Buy low, and sell high.
But what is ‘low’ and what is ‘high.’ These are relative terms that are worthless to the trader that doesn’t know how they want to define their entries.
We tackled this topic in-depth in the article How to Build and Trade a Trend-Following Strategy. In the picture below, taken from the article, we show you how traders can look to approach a trend-trading strategy using price action:
Trend Traders Want to Buy Low, and Sell High
Price action can be hugely beneficial when trading in trends, but many newer traders may have difficulty grasping the best way to employ this type of analysis into their trend trading approaches.
Another alternative is for traders to use simple indicators to define the trend and enter in the direction of that trend. This can even be taken a step further using Multiple Time Frame Analysis.
So, for example: A trader can use the 200 period moving average on the daily chart, and if price is above the moving average they are looking to buy while if price is below they are looking to sell.
They can then go down to the 4-hour chart to look for MACD signals in the direction of that trend. So if the trend was up on the daily chart, the trader wants to see MACD crossing up and over the signal line for a trigger into a long position.
When MACD crosses down and under the signal line, the trader can look to exit the position; and can look to re-enter on another bullish MACD crossover provided that the trend is still ‘up’ per the daily chart.
Unfortunately, trends don’t last forever. Eventually prices get so high, or so low that new buyers or sellers are hesitant to enter the market. This can create congested or ‘back-and-forth’ types of markets that can be daunting to speculate in.
But there are two ways to approach such situations… in the first, the trader can look for this ‘ranginess’ to continue; looking to sell resistance, or to buy support with the expectation that prices will move to the other side of the range.
We looked at various ways to do this in the article, How to Trade Ranges.
Once again, price action can be of huge assistance; as noticing that prices have been range-bound is a necessity for being able to speculate in this type of condition in the first place. Below, we show a picture from the article How to Analyze and Trade Ranges with Price Action that illustrates how exactly a trader can look to do this using price, and price alone.
Price Action Helps Traders See Price Levels that Have Been Important
But ranges, like trends, don’t last forever. When a range is violated, a new market condition comes about…
Breakouts are one of the more difficult market conditions to master, as the accompanying price movements can be volatile, violent, and extremely costly if we find ourselves on the wrong side of the move. We covered how traders can approach this condition in-depth in the article, Trading the Break.
But breakouts emanate from ranges. In many cases, a piece of news or some type of fundamental driver will create enough supply or demand in a market so that the previously established range breaks; and when that happens the move can be massive.
Breakouts Come From Ranges, and Lead to New Trends
Taken from Trading the Break
The problem with breakouts is that it might take three or four breaks of resistance to actually catch the move. So traders are usually best advised to be even more aggressive in their risk management of such strategies; looking for three or four times the initial risk amount when the breakout succeeds.
A Final Note on Life Cycles
Markets are unpredictable, as are the various life cycles that they may exhibit. Analysis is simply a way to try to get probabilities on our side, if even just a little bit. Noticing the market condition and employing the appropriate strategy is a key variable to increasing the effectiveness of that analysis, but risk management is the tying bind that makes long-term profitable trading possible.
-- Written by James Stanley
James is available on Twitter @JStanleyFX
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