April 25
Traders (especially retail traders) should follow the market; buy when the market is in an uptrend and sell when the market is in a downtrend. If only trading was this simple!
In addition to the market’s direction, you will need to understand the different market types to give you an edge. This will help to reduce the chance of you succumbing to the deadly concoction of fear and greed.
Let’s dive in to the 4 market types you need to know.
What is it? How does it look like?
This is the nice trending market type that is smooth (tiny gaps are acceptable). Prices are also in a narrow range, usually below 15%.
In the example above, the price range of MCD is between 8 and 9% as shown by the boxes in dark blue.
In the context of work, think about a highly reliable colleague. S/he is likely to be well loved by everyone in the office. That’s what a Type 1 market is.
Which strategy should you use?
Trend following. You know that your stock will most likely hit its target price.
This is the dream market type of every trend trader (aka technical analyst. See point 3 for an elaboration) as there is momentum and the pullbacks are shallow.
Your stop loss can be tight to help you maximize profits. Did you know that there are 5 ways to determine where to place your stop loss?
What is it? How does it look like?
This is a volatile trending market type; the candles are larger and gaps are common (indicated by the grey ovals).
From the chart above, did you notice that the price range is larger, between 24 and 30%? The price range is displayed by the boxes in dark blue.
A Type 2 market is like a roller coaster ride. You’ll meet the high peaks and the drop can be pretty drastic.
This market type is like the colleague who is reliable but has occasional mood swings.
Which strategy should you use?
Trend following.
Due to the deeper pullbacks in the stock price, you will need a looser stop loss.
The stock may hit its target price faster than Type 1; within days or a couple of weeks, depending on the time horizon you have planned for.
What is it? How does it look like?
The stocks in this market type is ranging in a tight band, usually less than 15%.
WMT’s share price has been caught in a Type 3 market, with a range of 9%. The range looks huge due to zooming in. Mind tricks, my friend!
This market type is like the colleague who is super calm and almost emotionless, almost robotic.
Which strategy should you use?
Since the price of stocks in this market type doesn’t move enough for any meaningful trades, it is best to avoid this market type until a trend emerges (think Type 1 and Type 2 kind of markets).
What is it? How does it look like?
This market type is stuck in a range (think Type 3) and is volatile (think Type 2). In addition, the range in a Type 4 market is loose.
Hang on! Didn’t I also use the chart of MCD as an example of a Type 1 market?
Yes! Stocks can (and most stocks will) exhibit the 4 different market types over time. From 2008 to 2009, MCD has been stuck in a wide range of 21%!
Do you have a colleague who is highly temperamental most of the time? One moment, s/he is laughing and agreeing with you on everything. The next moment, mad and not seeing you eye to eye even if your suggestions are great. That’s how a Type 4 market looks like.
Which strategy should you use?
Given that the price range is large, there is opportunity for money to be made. How?
You can make money by buying off the bottoms and selling near the top; and short selling off the top while covering near the bottom of the range.
Place your stop loss outside of the range. Add in some buffer for those occasional false breaks.
Discovering and identifying the different market types is easy and a must. It gives you an edge, knowing which strategies to employ and what to expect. Over time, you will gain confidence and find success in trading.
Great! We have covered a lot of ground analyzing the big picture of the market and stocks. We will zoom in, focusing on candlesticks, next week. So, stay tuned!
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