Market Adaptive Trading Techniques : Understanding Basic Market Statistics

MAT STEP TWO: UNDERSTANDING BASIC MARKET STATISTICS

The second step in developing a market adaptive trading plan is to 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. Understanding how the market usually behaves in these common situations helps traders adjust their position sizes and the number of positions being traded to more closely match the risk levels in the market.

The market rarely goes straight up or down; it usually runs a bit, then pulls back, then runs some more. Should traders be more aggressive on taking trades after the market has run up a bit, or should they wait and be more aggressive after the market has pulled back? Knowing how the market usually behaves after run ups or pullbacks allows traders to better position themselves to profit when the market does the statistically “normal” thing.

Understanding how the market usually behaves in a given situation allows traders to adjust their trading style and risk management to the current market conditions. For example, if it is better to buy new lows than new highs, then traders could take larger positions and more of them when the market is making new lows and take more profits when the market is making new highs. The information below shares research into how the market typically reacts to common situations so traders can position appropriately.

SHOULD YOU BUY AT NEW HIGHS OR NEW LOWS?

The idea of trading is to be positioned to profit if the market does the normal or usual thing in a given situation, and this is where basic market statistics come into play.

For example, let’s look at the question: are you better off buying when the market is making new highs or new lows? Most traders have an opinion on this, but very few have actually tested the proposition to determine what the best answer is. Remember, don’t rely on opinions—trading based on testing and analysis is what gives you an edge.Figure 8.1 shows the test results for testing the idea of buying when the market makes a new high. The test covered a four-year period during which the market was purchased whenever it made a 10 day high. The position was held for five days and then closed. The results indicate winning positions slightly over half the time and an annualized ROI of more than 5%.

FIGURE 8.1: BUYING 10 DAY HIGHS

What if instead of buying the market when it is making a new 10 day high, we buy the market when it is making a new 10 day low? The results are very interesting. As shown in Figure 8.2, buying new 10 day lows resulted in about the same percentage of winning trades as buying 10 day highs. The difference was that buying 10 day lows results tripled the annualized ROI. This is a significant difference and worth further investigation.

FIGURE 8.2: BUYING 10 DAY LOWS

In order to check whether or not there is something unusual about 10 day highs and lows, I repeated the experiment using 20 day highs and lows. Figure 8.3 shows the four test results for buying the market when it makes a 20 day high, holding for five days, then closing the position. This technique showed significantly better results than buying 10 day highs, and slightly better results than buying 10 day lows.

FIGURE 8.3: BUYING 20 DAY HIGHS

Figure 8.4 shows the four test results for buying the market when it makes a 20 day low. The results show an annualized ROI about double that for buying 20 day highs. Whether considering 10 or 20 day periods, the four year test results indicate that buying when the market is making new lows yields at least twice the annualized ROI than obtained by buying when the market is making new highs.

FIGURE 8.4: BUYING 20 DAY LOWS

Buying extended markets can be profitable. Buying market pullbacks can be more profitable. This is one reason why there are so many different pullback trading systems. I have developed and tested several different ones that I use every day. Would I just blindly buy the market every time it pulls back? No, there is, of course, more to the story; however, when the market has pulled back on light volume after running up on strong volume, I start trading larger positions and more of them. I adapt my trading style to the rhythm of the market based on the test results.

The test results for buying at new highs and new lows indicate that buying after the market has pulled back yields better results than buying after the market has run up. Given this data, I adapt to what the market is doing by increasing my market exposure when it bounces after a pullback. I do not trade the same number of positions or use the same position sizes all the time. I adjust my position sizes and number of trading positions based on the risk level that the market is presenting.

HOW SHOULD YOU RESPOND TO GAPS?

Traders frequently ask how to respond to times when the market gaps. Once again, the way to develop a plan is to use backtesting techniques to see what happens when the market gaps at the open. In the 100 days prior to 8/19/05, the NASDAQ gapped up 50 times and filled the gap up 64% of the time. It gapped down 50 times and filled the gap down 76% of the time. During this period, opening gaps were common and quite likely to be filled before the end of the day.

I tested gaps in two additional 100 day periods to see if the pattern held. In the 100 days prior to 5/19/05, the NASDAQ gapped up 59 times and filled the gap up 69% of the time. It gapped down 41 times and filled the gap down 78% of the time. In the 100 days prior to 2/18/05, the NASDAQ gapped up 52 times and filled the gap up 63% of the time. It gapped down 48 times and filled the gap down 83% of the time. Once again, the data indicates that opening gaps are common and that they are usually filled on the day they occur.

Based on this data and a number of years of observing the market, I respond to the market’s tendency to gap at the open by typically not trading during the first 20 to 30 minutes of trading. This gives the market a chance to settle down and pick a direction after the opening gap. The market often moves in the direction of the gap after filling it, so waiting a bit may provide the opportunity for a slightly better price. Once again we can use the results of testing the market to add to our collection of ways to adapt our trading to the market’s tendencies.

HOW SHOULD YOU RESPOND TO TOP OF THE RANGE CLOSES?

I once heard a speaker say that since the market had closed near the top of its range, it would be moving up tomorrow. Once again, I would advise you to test ideas and see if they really provide an edge in trading. This is what market adaptive trading is all about—gathering data on how the market typically behaves in common situations, then using that data to determine how aggressive to trade. I ran several tests to look at whether or not the market closed up the day after closing in the top 10% of its range and found the following:

• In the 100 days prior to 8/19/05, the market closed in the top 10% of the range 29 times and was up the next day 12 times.
• In the 100 days prior to 5/19/05, the market closed in the top 10% of the range 20 times and was up the next day 6 times.
• In the 100 days prior to 2/18/05, the market closed in the top 10% of the range 23 times and was up the next day 13 times.

Based on this data it appears that closing in the top part of the day’s trading range does not strongly influence the direction that the market takes the next day. It would not be wise to increase the number of trading positions being traded or the position sizes based on the market closing in the top part of the daily range.

When the test data indicates there is an edge, like buying into pullbacks, I increase my position sizes because the odds favor positive results. This does not imply that it always works, just that over the long run the odds are favorable. When I find information like the data above indicating that closes in the top part of the range do not strongly affect the next day’s direction, then I do not increase position sizes when that occurs because there is no advantage or edge to it. Market adaptive trading is about finding conditions that give you an edge an then using that to your advantage.

SHOULD YOU TIME THE MARKET USING INDICATORS?

Some traders monitor the stochastic or MACD indicators to help them determine whether or not to be in the market. Most indicators by themselves do not test well in terms of timing the market. Figure 8.5 shows the results of testing the stochastic indicator for market timing. A simple test involved buying the market when the stochastic moved from under 20 to above 20, holding the position for five days, and then closing it. During the three year test period, this technique produced winning trades less than half the time. I am not interested in using something that is right less than half the time to determine when to be in or out of the market.

FIGURE 8.5: MARKET TIMING WITH THE STOCHASTIC INDICATOR

Figure 8.6 shows the results of a three year test using the stochastic indicator to time shorts. The market was shorted when the stochastic fell from above 80 to below 80. Positions were held for five days and then closed. During this test period, less than half of the short trades were profitable.

FIGURE 8.6: TIMING SHORTS WITH THE STOCHASTIC INDICATOR

I have learned to focus on the price and volume patterns of the market and do not rely on indicators. I have found that using trend lines on the NASDAQ is more productive than the indicators I’ve tested. The trick to using trend lines and support/resistance levels is to know what to do when the market approaches or breaks them.

MARKET BEHAVIOR CHECKLIST

Based on these tests and a number of others, I have formed a basic check list to consider when trading. These are not hard and fast rules, but are a part of the things I take into consideration when reviewing whether or not to take a trade and how much to risk.

• Trade 10 or 20 day lows more aggressively than breakouts to new highs.
• The market gaps at the open a vast majority of the time; gaps are filled 2/3 of the time. Keep your powder dry on the open.
• Closing in the top of the range does not imply the market will be up the next day.
• The market is up more than four days in a row infrequently, so be cautious buying into runs.
• The market rarely trades less than 10 points or more than 35 points in a day. Be careful entering after a big move. If the market has not moved 10 points, watch for an entry.

There is a lot more market data that can be useful in determining when to trade and when to stand aside. An entire book could easily be devoted to the subject. The point here is that knowing how the market usually behaves can guide trading actions. For example since buying market lows shows better test results than buying market highs, I tend to increase position sizes when the market is bouncing from a low volume pullback.