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Article Market Type and Its Measurement by Van K. Tharp, Ph.D.
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Article
Market Type and Its Measurement
& An Interim Market Update
by Van K. Tharp, Ph.D.
View On-line
My market type methodology is nothing more than a descriptive statistic, something like a trend line. When the market is going up, or bullish, you should be long the market. When it’s sideways, trend following doesn’t work too well. And finally, when it’s going down you should be in cash, using short positions, or be in alternative investments.
Many of our readers have asked about how to calculate the Market SQN so that you can do it yourself. Well, I’d prefer to keep that proprietary but I am happy to share a way that is just as meaningful, easy to interpret, and it’s very simple to calculate.
Importance of Market Type
Basically, my definition of a bull market is one that’s going up. A neutral (or sideways) market is one that moves sideways in a range — or perhaps a bigger range if volatile. And a bear market goes down.
Market type has no predictive value, it is just descriptive. In other words, you never will know how long it is going to last. But you don’t need prediction to make money. You just need wins that are bigger or more numerous than your losses which need to be smaller or fewer.
In addition, you can learn a lot about what works and what doesn’t work when you use a particular market type that fits your time frame and how you want to trade. That concept is extremely important because two key Tharp Think principles are:
- It’s easy to design a good system that works well in any one market type and
- It’s insane to expect that same system to work well in all market types.
In fact, I have recently focused our Systems Development workshop upon the principle of creating trading systems for particular market types.
Measuring Direction Without the Market SQN
For measuring the market direction, I personally use the Market SQN calculation because it tells me about the efficiency of the move. At the same time, however, I also know this confuses some people.
Thus, if you want to know whether the market is going up, down, or sideways, I recommend you use the range change for that period as a good way of measuring direction. You simply calculate the change in price over the time period you are interested in as a percentage of the first price. I use the daily closing price.
I recommend that you use 100 periods, but the period size could really be anything. For example, we will give the 100 day range change % now in our monthly updates (in addition to the Market SQN scores for 200 to 25 days). But 100 days might not be useful to you if you are a swing trader or a day trader. Swing traders might want to use 100 hourly bars. Day traders might want to use 100 10-minute bars. Why? Because your market type process also has to reflect the type of trading you do and must relate to your system's holding period horizon.
Market Type Interim Update
With the market continuing to hit new highs in recent closes, some of you have been questioning how I can say that the market type continues to be Neutral (Quiet volatility) right now. If you have that question, then look at the table below which summarizes 15,000 days of data by showing the percentage change over each 100 day period for the S&P 500 as a function of our already defined spectrum of market types: strong bull to strong bear.
Market Type (100 Days) |
% Change Mean |
% Change STDEV |
Strong Bull |
15.06% |
5.42 |
Bull |
8.23% |
3.49 |
Neutral |
2.61% |
2.00 |
Bear |
-3.92% |
5.67 |
Strong Bear |
-11.99% |
7.01 |
During strong bull and bull market types, the percentage change averages are 15.06% and 8.23% respectively.
Now let’s consider the Neutral market type for a minute. Using my Market SQN calculation, I define neutral as the range from a Market SQN score of +0.7 down to 0.0 because it gives me plenty of warning before a nasty down move could occur. In October 1987, that warning for the SQN 100 was only one day before the 20% drop. (A smaller time frame, say 50 days, would have given a little more warning.) Notice the table above, the mean range change for the Neutral market type is 2.61%.
Now, let’s look at the next table which shows the recent dates, the all-time S&P high closes, the Market SQN score and the percent change for each.
Date |
New All Time
High Close |
Market SQN (100 days) |
%
Change (100 days) |
6/06/14 |
1949.44 |
1.00 - Bull |
7.16% |
6/05/14 |
1940.46 |
0.75 - Bull |
5.32% |
6/04/14 |
1927.88 |
0.69 - Neutral |
4.88% |
6/02/14 |
1924.97 |
0.68- Neutral |
4.74% |
5/30/14 |
1923.57 |
0.75 – Bull |
4.89% |
5/29/14 |
1920.03 |
0.69 – Neutral |
4.84% |
5/27/14 |
1911.91 |
0.50 –Neutral |
3.44% |
5/23/14 |
1900.53 |
0.47 - Neutral |
3.23% |
5/13/14 |
1897.45 |
0.90 - Bull |
6.54% |
5/12/14 |
1896.65 |
0.85 - Bull |
6.16% |
In the Market SQN column, you can see the Neutral market types and that the scores for the Bull market types don’t get much above the .7 dividing line. In the far right column, notice the percent change figures for the 100 days prior to each recent new high. The S&P 500 has been operating in a very narrow range in the last few months. Is this tight range a warning? Perhaps, but once again we don’t make predictions using market type. What you need to know right now is that this market is moving sideways — with a slightly upward bias — even though all you hear about in the news is that this market keeps making new highs.
Will the market continue to make new highs? Perhaps! Is the Neutral market type a warning sign that the markets will turn around and head down? Again, the answer is perhaps! But what the market type measurement really tells us is that we are in a sideways quiet market right now and if your trading systems are not performing very well, this could be the reason why. It doesn’t matter that the S&P is making all-time highs because this market has low volatility and a very narrow range — at least over the last 100 days.
Just a reminder — the high SQN 100 score for the year was 2.02 on January 14th and the market type on that date was Strong Bull Quiet. In the 100 day period prior to January 14, the market had risen strongly (Strong Bull) - compared with the smaller percentage changes (Neutral) recently. If the market keeps making new highs through June, however, it will have to break out of its narrow range and will again move back to Bull/Strong Bull. Notice how the range change has increased from 3.23% on 5/23 to 7.16% on 6/6. This is basically how the market type evolves and tells you exactly what is happening and what should work.
Calculating the Percentage Change
So let’s calculate the 100-day range percentage change. On May 30th, the S&P 500 closed at a new record high close of 1927.57. We also need to know the close of the S&P 500 one hundred days ago. 100 days ago it closed at 1837.88. First, calculate the range by subtracting the close 100 days back from the close on May 31.
1927.57 – 1837.88 = 89.69
The difference is 89.69 and now we divide that by the initial close for the period.
86.69 ÷ 1837.88 = .0489
If we calculate that as a percentage change, we get 4.89%.
What makes a bull, sideways or bear market type? You might say that anything above a 5% move is bullish, anything between -4.99% and +4.99% is sideways, and anything below -5% was bearish. Although I would suspect that anything below zero was bearish unless it was coming back from a deep bear market. You can pick the figures for yourself. And if you don’t like 100 days, use 100 hourly bars or 100 five minute bars.
And that’s it — you can keep track of the market type for yourself. Whatever period you use, you need to collect a lot of data so you know the historical precedents. For example, I looked at percentage change for 100 day periods and 400 day periods over the last 50 years — over 15,000 data samples. This is what that research revealed:
15,896 days |
|
100 Day % Change |
|
Average = |
|
3.34% |
|
Standard Dev = |
9.60% |
|
Max = |
|
45.85% |
|
Min = |
|
-41.44% |
15,625 days |
|
400 Day
% Change |
|
Average = |
|
13.83% |
|
Standard Dev = |
21.28% |
|
Max = |
|
77.27% |
|
Min = |
|
-53.90% |
|
|
|
|
Over a 100-day period, you can expect the S&P 500 to go up about 3.34% on average; however, the standard deviation is 9.6%. The average minus one standard deviation gives us a -6.26% return — something that should not surprise us in the least. At the extremes, it has moved as much as +46% or -41% in 100 days.
Over 400 days you can expect an average return of 13.83% — which is why the pundits say buy and hold. Look, however, at the standard deviation of 21.28%. We can still expect a good number of 400 day returns in the 0 to -7.5% range — a range less than 0 but within one standard deviation below the mean. And the extremes are now +77% and -54%.
Conclusion
The Market Type, regardless of whether I use my Market SQN or you calculate the percentage change, does not predict what’s going to happen. It does tell you what’s happening right now and whether or not we are in a market climate in which your systems should work well or not. I recommend that you use some kind of market type process if it fits your beliefs.
About the Author: Trading coach and author Van K. Tharp, Ph.D. is widely recognized for his best-selling books and 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.vantharp.com. His newest book, Trading Beyond The Matrix, is available now at matrix.vantharp.com.
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Trading Tip
Event-Driven Momentum —
Is There Real Price Follow-Through?
by D. R. Barton, Jr.
How wonderful that we have met with a paradox. Now we have some hope of making progress. — Niels Bohr, Nobel Laureate
The bears are crying and the shorts have been squeezed. Momentum is winning the day and last Friday’s Non-Farm Payroll (NFP) announcement (aka the monthly employment numbers) added more fuel to the flame. The day before the employment figures, Mario Draghi got the party started by taking the European Central Bank (ECB) into the unchartered territory of offering negative interest rates — basically charging banks to park their money there. He also said, that, if needed, the ECB was not yet out of monetary cards to play. And the market loved it.
The string of recent all-time highs got me thinking about how often markets follow-through on pushes to the upside. I remembered anecdotally that David Tepper’s positive comments last May kept the markets zipping merrily along for weeks. And Draghi’s most famous uttering to date — his “whatever it takes” speech from July of 2012 — moved the market ahead for the better part of two months. It seems that, in general, event-driven momentum begets more momentum.
But those of you who have seen how my squirrely little mind works know that I wouldn’t be satisfied with some piecemeal examples. So I started digging around to see if any of my favorite quants have done any work on momentum. I found several pieces of research, but none more relevant than a study of momentum follow-throughs after monthly employment announcements. Let’s see what the reaction to the last five years of announcements tells us.
What Happens When the Market Likes the Employment Numbers
Since January of 2009, there have been 65 NFP (monthly employment) announcements. The data diggers and numbers crunchers over at paststat.com show that out of those 65 announcements, 21 have elicited a move in the S&P 500 of more than 0.5% on the Friday when the numbers come out.
The question before us is whether this NFP event — the most anticipated economic announcement each month — provides price momentum in the market when the initial reaction is positive. A word of warning: the following chart is a bit busy, but it is useful enough to present as raw data. Let’s take a look and then we’ll draw some conclusions:
Exit |
# |
Wins |
% Wins |
Avg % |
Med % |
Avg Win % |
Avg Loss % |
Pay off |
Max Loss % |
| t+1 |
21 |
16 |
76.2 |
0.51 |
0.38 |
0.87 |
-0.64 |
1.35 |
-0.89 |
| t+2 |
21 |
15 |
71.4 |
0.66 |
0.18 |
1.17 |
-0.64 |
1.84 |
-1.53 |
| t+3 |
21 |
14 |
66.7 |
0.40 |
0.22 |
1.26 |
-1.30 |
0.97 |
-2.16 |
| t+4 |
21 |
10 |
47.6 |
0.41 |
-0.13 |
2.14 |
-1.17 |
1.84 |
-2.45 |
| t+5 |
21 |
13 |
61.9 |
0.71 |
0.97 |
2.06 |
-1.50 |
1.38 |
-3.36 |
| t+10 |
21 |
11 |
52.4 |
0.27 |
1.33 |
3.27 |
-3.02 |
1.08 |
-8.44 |
| t+20 |
21 |
13 |
61.9 |
0.46 |
0.86 |
3.38 |
-4.18 |
0.79 |
-18.50 |
| 1st +'ve exit in 5 days |
21 |
19 |
90.5 |
0.64 |
0.39 |
0.87 |
-1.57 |
0.56 |
-2.64 |
(Source: www.paststat.com)
Some explanation of the data before we get to conclusions:
- t+1, t+2, …t+20 = one day after NFP, two days after, … 20 days after
- Pay Off is the ratio of average win divided by average loss
- 1st +’ve (positive) exit in 5 days = exiting after the first positive close in the first five days; if not exit after day 5. This produced 19/21 winners, with the worst loss being -2.64%
Non-Farm Payroll Follow-Through: Conclusions
So what can we say about momentum after a NFP announcement? First of all, for the past 5½ years, only about a third of the reporting days produced meaningful bumps up in price.
Secondly, when we did get a 0.5% or greater move, there was some meaningful follow-through, but it started to dwindle after three days.
What can we do as traders? As I’ve been saying in this space, continue to enjoy the momentum for now; but do watch for signs of a break. We have a very old bull market, but it shows few signs of tiring just yet. Nine of the last ten days (ending with Monday’s trading) have given us new all-time highs in the S&P 500. But with the Fed, the ECB and other central banks working hard to provide liquidity, it’s tough for the bears to “fight city hall” right now.
As always, your thoughts and comments are always welcome - please send them to drbarton “at” vantharp.com
Great Trading,
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".
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