Market Adaptive Trading Techniques - TheForex7

MARKET ADAPTIVE TRADING TECHNIQUES

In the previous chapters of this book, we looked at several common candlestick patterns and used backtesting techniques to determine how often they were successful. We also developed an understanding of how variations of the pattern definition, and different filters, affect trading results. Developing, testing, and understanding a set of tools, or trading patterns, is one of the key steps in successful trading.

Another key requirement of successful trading is the ability to analyze the current market conditions in order to determine appropriate risk levels and to select the best patterns for trading. Remember, most patterns are more effective in certain market conditions and matching the right tool to the job can help us trade more effectively. Trading the same pattern all the time may just churn the account. Traders need to use their research to trade the most statistically favorable patterns.

Analyzing the price and volume patterns in the market and then selecting the best trading tools and using appropriate risk management is a process I refer to as market adaptive trading (MAT). Since the market will not adapt to us, we must adapt to it. Trying to predict what the market will do, or to what level it will move, is difficult to do and, more importantly, not necessary. Successful traders analyze the current market conditions and then develop a trading plan that outlines what the market would have to do to make them focus on longs, shorts, or cash; in addition, they determine how much risk to take in a given market environment.

The market has three basic modes; it can be trending up, trending down, or moving within a trading range. As shown by our candlestick pattern testing, most trading tools work best in a trending environment; and thus, when the market is trending, I tend to trade more positions and use larger position sizes. Trading ranges diminish the results of many trading patterns, and I compensate for the increased risk by reducing position sizes and the number of positions I trade.

Trend lines are one of the best tools for determining when the market is moving from one mode to another. If the market is in an uptrend, then it has to break an ascending trend line to move to a significant basing area or start a downtrend. Similarly if the market is in a downtrend, it has to break a descending trend line in order to form a significant base or start a new uptrend. Trend line breaks are usually a time to adjust risk by changing position sizes and the number of positions being traded.

Trend lines drawn on the NASDAQ chart are one of the trader’s best friends. When the NASDAQ is trading above an ascending trend line, I focus on trading longs using patterns that have tested well in bullish markets. When the market is moving below a descending trend line, I focus on trading patterns that have tested well in bearish environments. When the market breaks a trend line, it is a call to action. It indicates that conditions may be changing, and I reduce risk by reducing position sizes until the market makes its intentions clear.

The Market Doesn’t Care What You Believe

Market adaptive trading is not developing a trading plan based on what you feel the market will do, or based on what the “experts” are saying it will do. In short, no one knows what the market will do; it is best to make a plan for each of the three basic actions that market can take, then trade the plan.

Listen to the market, not what people are saying about it. For example, at a recent trading conference I heard the following statements from those who are considered market experts.

• I continue to believe oil stocks are going to pull back.
• I didn’t make money in it the last time I got involved and am inclined to believe that the best way to handle an investment or trade in BAX is employing patience.
• I believe that this instrument will deliver gains from this point going forward. That is why I am involved. No other reason.

The issue with all these statements is that they are presenting a belief, with no real information about why it might be true. It is great that someone believes oil stocks will pull back, or that some stock will deliver gains going fore word. The fundamental issue, of course, is that the market does not care what we believe. We can believe something as strongly as we want, the market will not care.

The market shows us what it thinks through price and volume patterns. Learning to read these patterns is a key part of trading success. Predicting how far the market is going to move, or what the year end closing value will be has little value since no one has been able to consistently do this year after year. However, reading the market’s price and volume patterns to determine how much risk to be taking and what tools to be using is something that can be of great benefit to traders.

Rather than trying to forecast direction, traders should focus on identifying key trigger levels and then trading with the market. Traders need to use tools from their trading tool box that are appropriate for the current market conditions. Knowing how each of the tools in the trading tool box performs in each of the basic market modes allows traders to select the most appropriate tool to be using. Using the same trading tool in all market conditions will just give traders a lot of practice exercising stops.

There are several steps to developing a market adaptive trading (MAT) plan.

Step One: Develop, test, and understand several trading patterns. These are the tools in the trader’s tool box. The first seven chapters of this book have outlined this process for several candlestick patterns.

Step Two: Understand basic market statistics. If traders do not know how the market reacts in common situations like new highs, new lows, gaps, closing in the top or bottom of the range, etc., then they cannot capitalize on the fact that these common situations can provide leverage for knowledgeable traders.

Step Three: Use trend lines on the NASDAQ chart. This technique keeps traders focused on using the right tools for the job and helps them determine when to reduce risks.

Step Four: Write down your daily trading plan. Look at the current market conditions and determine if they are favorable to trading longs, shorts, or remaining in cash. If the market is in a clear trend, then normal position sizes may be used. If the market is in a trading range, then half size positions may help compensate for the increased risk.

Now, let’s look at each of these steps in more detail.

MAT STEP ONE: DEVELOP, TEST, AND UNDERSTAND TRADING TOOLS

The first step in market adaptive trading is to develop, test, and understand several trading patterns. These are the tools in the trader’s tool box. As we have seen, testing identifies filters that can improve a pattern’s trading results and the best market conditions in which to use the pattern. We can then use trend lines to determine when to switch between different trading tools.

The trading tools we have developed so far are the bullish engulfing, bearish engulfing, hammer, hanging man, morning star, and evening star candlestick patterns. These are the tools available to us for trading and should be selected for use when the market conditions are most favorable for a particular pattern. A quick summary of what we’ve learned is below.

BULLISH ENGULFING PATTERN SUMMARY

The bullish engulfing pattern is one that shows positive results in multiple timeframes. We saw that two simple additions to the basic pattern definition significantly improved the results. This trading pattern should be avoided when the market is in a downtrend.

The pattern was also significantly improved by focusing on trading those that have above average volume on the first day. The effort put into backtesting allowed us to quickly analyze the results of thousands of trades and find two simple techniques to nearly triple the annualized ROI for this pattern.

BEARISH ENGULFING PATTERN SUMMARY

We found that the bearish engulfing pattern may be improved by: using it in downtrending or bearish markets; using a three to five day holding period; using it on higher-priced stocks; looking for volume on the second day of the pattern that is larger that the volume on the first day of the pattern; and taking patterns when the top of the second day’s body is at least 15% of the day’s range above the top of the first day’s body.

Based on the test results shown in chapter three I would not trade the basic bearish engulfing pattern in all markets. I would confine its use to bear market conditions, and I would use the volume filter. It would not be the only pattern I trade, but is an interesting addition to the trader’s tool box and one of the patterns I look at when the conditions are right.

HAMMER PATTERN SUMMARY

Through our testing, we found that the hammer pattern may be improved by: requiring the upper shadow be at least 5% of the day’s range; trading stocks priced under $30, trading stocks with average daily volume under a million shares; trading with volume at 160% or more of the previous day’s volume; trading hammers whose range is the largest range of the last 5 days.

The results in chapter four indicate that the basic hammer pattern can be significantly improved by only trading the pattern when the day’s trading range is the largest of the last five sessions. Since the wide range hammer filter nearly doubles annualized ROI in tests involving two different timeframes and covering almost five years, it is something worth considering when trading this pattern. The wide range hammer generally does not test well during periods when the market is in a downtrend. 

HANGING MAN PATTERN SUMMARY

Our results showed that the hanging man pattern may be improved by trading the pattern in bearish markets and requiring the pattern to occur as the highest high of the last five days. Even with these improvements, the hanging man pattern was not as effective as the others. Some patterns are good tools to use, and some patterns are best left alone.

The basic hanging man trading pattern, discussed in chapter five, does not produce favorable results when used continuously through a variety of market conditions. It is not an all-weather tool. It does show good results in several downtrending or bear markets. In fact, the market conditions have a much stronger effect on these results than any of the other filters tested. It should be avoided in uptrending or bullish markets. A holding time around five days seems to work best, and patterns that occur around recent highs may be more productive.

MORNING STAR PATTERN SUMMARY

Our test results indicate that the results of the morning star pattern may be improved by: trading patterns with a first day’s black body larger than the previous day’s body; requiring the second day’s body to be less than 60% of the day’s range; requiring the close of the second day of the pattern to be below the low of the first day of the pattern, when the second day of the pattern has a black body; and using a four to five day holding period.

In chapter six we found that the basic morning star pattern is statistically equal to a coin flip and after testing a number of different modifications and variations to the basic morning star definition, we found that slight changes to the definition of the morning star can significantly improve results. These slight changes to the definition take the pattern from a break even result to something that beats buy and hold and shows about 59% of the trades as profitable.

EVENING STAR PATTERN SUMMARY

After our testing, we found that the evening star pattern may be improved by: requiring that the third day of the pattern has a body length that is the largest body length in the last five days; taking evening star patterns with white space gaps on the third day; having the body on the second day of the pattern be white; and requiring the first day’s body to be the largest in the last three days, when recent average volume is declining.

The test results for the evening star pattern shown in chapter seven showed why I would not trade the basic evening star as first defined since the results were less than buy and hold and it showed losing trades most of the time. Using backtesting to analyze various parameter changes and filters resulted in changes that turned the original pattern from something I would pass on to something I would consider using.

Now that we have a better understanding of how each of the candlestick patterns perform, and have identified specific ways to improve the results of each pattern, we need to look at some basic market statistics. Knowing what the market typically does in common situations helps us to determine whether or not to be taking trades, and if so, how aggressively to be trading. There is a lot more to successful trading than just identifying a pattern and entering a trade.