We have all done it.
Embarked on the quest to find the Holy Grail of Forex trading – A system that produces consistent results week in week out with a limited drawdown and nicely upward sloping equity curve.
But there is a problem with the Holy Grail approach to system development that means the search leaves us more frustrated than enlightened.
And if you can understand that problem, then you will have the first key to Forex trading system development firmly within your grasp.
Market Types – the first key to Forex system development.
“Expecting the same system to work in all market types is the definition of insanity”
Market type refers to the different stages or states that a market flows through.
The market type concept was made popular by trading coach and psychologist Van Tharp in his books and courses. Tharp believes that while it is insanity to expect a system to work in all conditions, if you can define the market type then it is relatively easy to design a system that provides an edge in that specific market type.
Think about it.
If you are in a sideways volatile market should you be running your buy dips in a trend strategy? Or how many traders get blown out of the water trying to buy and hold a strong bear?
While there are up to 25 different market types according to Tharp, there are six that should be of primary consideration.
You can see market types in action if you study a price chart for a moment. You will notice that each currency pair is in constant flux. Sometimes it is trending nicely; at other times it coils into a tight range, or is choppy and volatile.
The core problem with most Forex Systems
The problem with most Forex systems (and incidentally why most Forex robots tend to fail in time) is that they are only designed for use on one market type.
If you instead shift your focus to identifying market types and then applying a system to that market type, you might find your Forex trading becomes more fruitful.
Awareness – How to identify the market types
Forex Market types are not so difficult to identify. Normally it’s just a matter of looking at a chart.
If the market is going up quietly then it is a bull normal market type. If it’s going down it’s in a bear normal. If it’s in a rapid descent or rapid ascent it’s a volatile market. If the price is oscillating between two support and resistance levels then it’s a sideways market. If the sideways range is wide then it’s sideways volatile, if it’s tight then the market type is sideways quiet.
The trick is remaining aware. Be centered enough that you can do the following.
To assist in this there is a very useful tool you can use to help you identify the market type.
Market type identification tool: Bollinger Bands
To my mind the best tool to identify Forex market types is the Bollinger Bands.
The technique here is quite simple.
Bring up a chart and apply the Bollinger Bands.
Bollinger Bands are a volatility based indicator. When they contract it is a sign the market type is normal or quiet, and when they expand that is a sign that the market type is more volatile.
You can also use the Bollinger Band to determine direction. If the price is bouncing off either side of the band then the market is sideways, if it is hugging either the upper of lower band then you likely have either a bull or bear market type.
Look at the following EUR/NZD 30 minute chart and tell me what market types you can identify.
How did you go?
Here’s what I found:
You can see the Bollinger Bands contract into a sideways quiet, followed by a break out to a bear normal, into a bear volatile. The next part is a bit harder to classify but it could be bull volatile or sideways volatile. Next it moves into a sideways volatile followed by a sideways quiet and finally what I would call it a strong bull.
Now you can identify market types is there anything else you notice on the chart?
The secret sauce – Market type transitions.
Markets are like the ocean.
The primeval forces of human emotion drive the ebb and flow of the price just as the wild and unpredictable forces of Mother Nature drive the tides of the seas.
Like the ocean, the market transitions from calm to restless.
A stormy night clears into a sunny day.
Choppy foam settles into a peaceful blue-green glaze… or morphs into a squally and dangerous tempest.
Just as sideways volatile settles into sideways quiet and then transitions into a strong bull.
There is an edge if you understand market types, but there is a greater edge if you understand the probability of what the next market type will be.
If you know that historically more often than not a bull volatile ends in a bear volatile then you can plan accordingly.
Similarly if you understand that a sideways quiet usually results in a break out to a bull or bear then you could develop a system to capitalize on this knowledge.
Trading is a statistical game and knowing probabilities is important.
Forex Market types across time-frames
Some of you may be wondering which chart time-frame you should be looking at determine the market type.
The fact is all charts will display all market types.
Really it comes down to preference.
The lower the time-frame the more agile you need to be in adjusting to changes – and the more likely you will get fake-outs, so be wary.
Higher time-frames give you more time to adjust to changing conditions and your trading efficiency (trading without mistakes) will be higher.
Importantly, a higher time-frame is often the set-up for the lower time-frame.
For example, once you determine the market type on the weekly charts you can slide down to the daily or hourly charts to snipe for an entry.
Personally I like to define market direction on the weekly or daily charts, and then move to a lower time-frame like the 15 minute chart for an entry. Shorter term market types seem to show up pretty clearly on the 15 minute chart so it could be a good place to start.
As a tip, you might notice the market changes type at certain times of day. Knowing this can be very valuable for your trading. You might not want to take a range trading position on the London open for example.
Manage your stops based on market type
If you know that a bull volatile typically turns into a sideways or bear volatile then you can adjust your stop types based on that information.
For example you might switch to using a Parabolic SAR with a steep gradient that keeps your stop nice and tight in a bull or bear volatile market, or perhaps you limit your risk to one or two times your initial stop.
Having an appropriate exit strategy that is intelligently adjusted depending on market type is a good way to keep hold of your profits on a trade.
Systems for each market type
At the start of this post I mentioned that trying to develop a system that works in all market types is the metaphorical search for the Holy Grail.
Instead you could look to build a system that works well in each market type and switch between them as the market type changes.
A lot of work? Yes it is. But is it worth is? Definitely.
Here are a few rough concepts for strategies that tend to work in each market type.
Bull Normal – Buy and hold
In a bull normal Forex market type you can simply buy and hold with a trailing stop-loss. As long as the market type does not change this can be a pretty successful strategy.
Tip: Watch for a change to a volatile market. You might find that that the bull market is coming to an end and it’s a good time to tighten your stop.
Here is an example on the NZD/JPY on a daily chart. Notice the long bullish candles and widening Bollinger bands at the top of the chart signaling a move to a more volatile market type. Here you would tighten your stop.
Bull Volatile – Long swing trading
Bull volatile markets are suited to a more active trading style. Profit targets are the order of the day in this market type. Look for a pull back, a reversal and then find a logical profit taking objective on the long side. You may want to consider dropping to a lower timeframe to improve the risk/reward on the entry.
Here is a bull market that has turned volatile on the AUD/JPY 30 minute chart. See how a buy and hold approach would have struggled while profit targets would have helped you capture the majority of each swing.
Bear Normal – Sell and hold
Bear normal markets are the opposite of bull normal markets. Sell short and hold with a trailing stop to help capture the majority of the move.
The recent fall in the AUD from 1.06 cents to 88 cents is a good example of this market type in action.
Bear Volatile – Short swing trading
In currencies the bear volatile is the opposite of the Bull volatile (this is not so true if you are trading stocks). Try a short swing trading approach with a profit target that gives you a good risk to reward on your trade.
Sideways Quiet – Breakout
There are two ways (at least!) that you can trade a sideways quiet market.
You can move to a lower time frame and use a band trading strategy (like in the sideways volatile section below). This approach can be very lucrative if the currency pair stays in this market type for some time. There will be lots of 2:1 and 3:1 risk reward trades you can pick off in a row.
Often sideways quiet markets result in a strong break-out and trend. Instead of trading the sideways quiet you can instead stalk the shift to a new market type by trading breakouts.
A break-out strategy is not for the faint-hearted.
You will face fake-out and false breakout and then need to have the psychology to hold on for the big wins. But a break-out strategy that is executed with efficiency is perhaps one of the most powerful strategies in the Forex market where trends can last a long time.
You can see the break out from a sideways quiet market below on this 4 hour chart of the USD/HKD.
Sideways Volatile – Band trading
Sideways volatile markets can be targeted with a band trading approach.
In the below example on the CHF/JPY 30 minute chart I have replaced the Bollinger Bands with moving average envelopes and customized the settings to the timeframe and currency pair.
With envelopes you want the majority of action (90% or so) to be contained within the envelope.
Once the price touches an outer envelope, look for a reversal off a support and resistance level to give you a nice risk/reward on your trade.
Don’t throw the baby out with the bath water.
If you have a good system that works sometimes, don’t give up on it.
Instead, identify the Forex market types it performs well in, and only trade those.
It’s like playing golf.
You pull a different club out of the bag for each different scenario you face. You would never use a putter to hit a tee shot, or a driver when you are stuck in sand.
The same applies to trading.
Build a toolkit of strategies that perform well in different conditions and use them as appropriate, depending on the market type.
The Hunt for the Holy Grail
Van Tharp still believes in Holy Grail systems.
But his definition is different.
To Van, the Holy Grail is a system that performs exceptionally well in a particular market type.
Think of it this way. If you know that you are able to meet your trading objectives for a system operating in a certain market type, then all you need to do is hunt for the market type you want to trade.
Its like being a golfer who excels at putting, and only plays on the putting green – and still win golf tournaments.
In trading you can take this approach.
You make the rules of the game so if you only want to trade one market condition you can.
As a side note, one of the reasons I like AxiTrader is that it has low spreads on cross-rates (currency pairs like the EUR/AUD or GBP/CAD) and not just the majors. Having access to more currency pairs with viable spreads provides me with plenty of forex markets to go hunting for the conditions I like.
If you would like to practice trading on different market types you can get a free demo account here.
The yield curve can provide insights into economic expectations for inflation, growth, and possibly changes in monetary policy. Learn more about the different types of yield curve here.