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One of the most oft-repeated comments made by traders over the past couple of years is, "The market has changed." The perception that traders must change their methods or indicators with the market seems to be so well ingrained that the idea is rarely challenged.
Having participated in the capital markets since 1984, I believe the statement needs to be qualified. We could say that the market is not going up as it did in 1999 or that it is not as volatile as it was before, but it might not be categorically correct to say that it has changed. Over the long run, there have been periods where the broad stock indices traded sideways for years on end, so what we have experienced over the past couple of years is not a new phenomenon.
To me, the market is doing what it always has; that is, it has periods where price action is dynamic, momentum is strong and there is plenty of liquidity because people want to play. Then, after a while, the market gets tired. A contraction in the trading range takes place, price action can become rather discontinuous and volume disappears. It is usually at this point that the mantra becomes "The market has changed."
We can substitute the words "the market" with a symbol, be it a stock, a commodity or a currency, and find similar episodes of price action. Instead of perceiving this as change, the desk and floor traders I worked with in the securities industry viewed the inevitable cycle as a game. When the game was on, they played. When the game was finished, they moved on.
It has been said that we need to "know when to hold 'em, when to fold 'em, when to walk away and when to run." What is overlooked is the question of when we should play, and most importantly, which game?
I often meet traders who have given up on their techniques or indicators in the name of change. When asked if the approach worked before, the answer is generally "yes," and they usually describe strategies designed for trends. When I tell them that these techniques are not supposed to work in choppy, sideways price action, they are often surprised. Even though there are only three broad categories (trend, reversal and breakout) of methods, they did not know where their particular setup fit in.
To make money, a trader needs to find the game and play it accordingly. For example, if you feel comfortable trading trends, you need to find where a trend is happening and play it with trend-following techniques.
Finding the game -- and knowing if it is on -- is not difficult. Let me show you some tricks of the trade.
Liquidity
We need volume. An auction with few bids and offers does not provide us with a good indication of price. We want to be in the company of lots of interested parties, people with whom we can trade, so we can execute our order at the best price. High volume and many transactions indicate that there are lots of players around.
Diminishing volume is a sign that the players have moved on.
Range
No matter how good our tools and techniques might be, they will not be effective if there is little fluctuation in price. We can use Average True Range to measure this so that we know what to expect. In general, we want to be trading symbols with expanding ATR readings. Extreme ATR readings also signal caution.
The 13-week Average True Range is a good indication
of what sort of price movement traders can reasonably
expect over the course of a week, based on price action
over the past three months. Back in 1999 / 2000,
the ATR reading was consistently over $10 on
the weekly chart. It is now just over $1.
Volatility
Range often goes hand in hand with volatility. For stocks, I consider a 20-day historical volatility reading under 25 and decreasing as "congested" while a reading over 25 and increasing means "the game is on".
Download the EFS from TS Support. Link to: http://www.tssupport.com/support/base/?action=article&id=1770. Be sure to adjust the number of days to look back to 252 because this reflects the average number of trading days per year.
On this daily chart of GOOG, I plotted the 20-day
Historical Volatility reading and the 20-day
Average True Range. This helps us identify
the character of the market, so we can apply
the appropriate technique to trade it.
So, there you have it -- a few tools that can be used to help us identify game on / game off status of any symbol and timeframe. You can also apply these as scanning criteria to narrow the list of desirable stocks to trade. Any time there is range and volume expansion, go ahead and put the symbol on a watch list.
When the game is on, traders come out to play. The easy part is to determine the appropriate amount of money to risk and apply a proven (trend, reversal or breakout) strategy with a stop loss.
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