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Feature
 Understanding
Market Type, Part II
by
Van K.
Tharp, Ph.D.
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
2. Bull, quiet
3. Sideways, volatile
4. Sideways, quiet
5. Bear, volatile
6. Bear, quiet
These
six conditions work 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.” So I prefer to just have six
market conditions.
When
I wrote the original article on market type, some people asked,
“Why? How can I profit
from this information?” Well,
the key to this is that you must totally 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.
It’s pretty easy to design a quality system for any one
market type. What’s
difficult is trying to make it work in all types of markets.
Some
people are trying to improve their systems continually, not
realizing that they already have a good system that only works in
certain kinds of markets. Instead of constantly trying
to 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. This
simple step could make you millions in the markets.
In
Part I of Understanding Market Type, I introduced you to three
different market types that we are analyzing currently.
The details of the three models are described in the May 20th
issue of Tharp’s Thoughts.
The table below shows the three market types for all of 2009
as of June 5th.
View
Larger Image
My Conclusions from Part I
First, the time frame of the
market type makes a huge difference in your conclusion. Thus, a 13
week method can show the market as bullish whereas a method based
upon the 200 day moving average can show the market as bearish.
Second, market type is
individualized based on how you trade. Day traders and swing traders
will have an entirely different view of market type than longer term
traders or investors.
Third, minor assumptions in how
you calculate market type can make a huge difference in the
conclusions you make. I had decided at one point to use Method 4 to
determine market type in my monthly updates.
But now that has changed.
From now on, I plan to start using Method 3 to determine
market type.
Let’s
look at the predictive value of the types by asking the following
questions:
The
Predictive Value of the Three Methods
The
table below shows the predictive value of the three methods through
the percent change for the following week after a market
classification is made. The
average weekly change for the following week is shown in the table.
The
results suggest that none of the three market types have much value
in terms of weekly prediction; thus, they are useless for
determining whether a system will work in that market type.
One reason why market type has such little predictive value
during a 13 week period is illustrated by the results of our last
analysis of market type, published on May 24th, when all
three market types gave very different readings.
Method
2 classified the market as volatile bull, Method 3 classified the
market as volatile sideways, and Method 4 classified the market as a
quiet bear. The market
had been going up enough to account be positive over the last 13
weeks (but not when you avoid dropping a last down week 13 weeks ago
as we do in Method 3); however, over the last 200 days (Method 4),
the market was still way down. This
resulted in mixed readings.
In
other words, you can have a bear market with huge up moves in the
last part of it, but not enough to make it net up.
Similarly, you can have a bull market with huge down moves in
the last part of it, but not enough to make it net down.
This makes market type have little predictive value.
In my next article on market
type, I’ll show you my latest research in market type using System
Quality Numbers™ of the daily percent changes.
We see how accurately these data represent market type and what
predictive value they have, if any, on a daily basis.
About
Van Tharp: Trading coach, and author, Dr. Van K. Tharp is
widely recognized for his best-selling books 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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