Forex Market Types
Forex Market Types and How to Profit From Them
Market Types for Forex by Dr. Van Tharp Trading Education Institute
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Perhaps the biggest mistake that many traders make is ignoring market types when they build their trading systems. Most traders tend to put blinkers on and try to use the same strategy no matter what the market is doing in-front of them. But having a trading system that works well in all conditions is difficult – if not impossible.
Your system might work well in trending markets and perform poorly in sideways markets. So why trade it in sideways markets? The simplest solution? Identify the market type, and then apply a strategy that works in that market type.
Identifying Market Types in Forex
There are several methods of identifying market types. Van Tharp uses a mechanical market type classification system that applies an algorithm for market direction and volatility. For my Forex trading, I prefer to use charts for their simplicity and ease of access. I have a simple framework and on the chart below, you can see quite easily multiple market types using weekly bars for the JPY/USD pair.
To identify market types in Forex, I use Bollinger Bands. Depending on the type of trade you are looking to place, you could use Bollinger Bands on the weekly, daily or even 4 hour charts. I tend to use the weekly chart to identify the market type, though I stalk entries off the hourly chart. The shorter your trading horizon, the lower the timeframe you will use.
The Bollinger Bands can be set to either 10 periods or the more common 20 periods. Both work, but have a different degree of sensitivity. If you are a “rules based” discretionary trader, don’t be afraid to play around with the indicator until it gives you the insight you desire. When I am trading, I often switch settings and timeframes depending on what I am trying to determine and achieve. Sometimes, mysteries on the weekly chart become very clear after looking at the 4 hour chart.
The width of Bollinger Bands can help you determine the relative volatility. When Bollinger Bands expand gradually, it is a sign of a normally trending market type. When they stretch out quickly, it is a sign of a volatile market type. When they contract, that’s a quiet market type. See the chart below for examples of each —
How the price bars interact with the bands helps you determine the trending portion of market type. If price seems to “push” the upper Bollinger Band up or the lower band down, that indicates a trending bull or bear market. If price bars generally stay between the two bands with no clear direction, the market type is sideways.
If you combine volatility with trend, you can generally identify the market type pretty easily.
While Bollinger Bands are very useful, market type identification can be improved by using price action.
Determining Market Type With Price Action
Price action allows you to identify bull volatile or bear volatile market types better than simply relying on Bollinger Bands. Price action can also help you to identify market type transitions early on.
Bull volatile and bear volatile markets can be identified by increasingly long candles or bars.
Rather than an orderly transition, the switch from a bullish to bearish market type (and vice versa) can be quite rapid. Price action can be used to identify this switch, as often the market type will change direction when it hits a significant support and resistance level.
For a sign of a market type direction change in the weekly price chart, look for candlestick reversals off of support and resistance levels or look for double tops and bottoms. Then, you can look for reversal setups in a more aggressive way by going down to the daily chart.
Just stay very aware of what is really going on. Reversals don’t always work out and sometimes the original direction can resume with a vengeance!
Strategies for different market types
Van Tharp believes that it’s nigh on impossible to build a Holy Grail system that works in all market types. Instead of trying to build Holy Grail systems, Van recommends that traders develop a number of non-correlated systems that each work well in different market types. This is generally a good idea as it will help improve your performance consistency and it will also teach you to think flexibly.
Let’s take a brief look at each market type and a simple strategy that you might apply in each one.
To identify a bull normal market type, look for the price to be trending with the upper band — above the mid Bollinger Band. Generally, bull normal market types suit trend-following strategies. Look for a pull-back or a consolidation phase and break-out to buy the direction of the trend.
In a bull volatile market type, you will see long bullish bars or candles when the price trends with the upper band. The price may frequently cross above the upper band itself. Bull volatile market types can suit short-term swing trading strategies. Stops should be kept tight, and profits left to run for some strong risk/reward trades.
Bear normal is the opposite of bull normal. The price trends with the lower bands and remains below the mid band. Like bull normal, look for pullbacks to key levels and consolidation phases with a break-out in the direction of the trend.
Bear volatile is the opposite of bull volatile. You will see long bearish bars develop that sometimes cross below the lower band. As in the bull volatile, look for swing trading opportunities in the direction of the trend. Again, keep tight stops and let profits run.
In a sideways volatile market type, the bands are wide and the price action includes large bars that just move sideways. Sideways volatile markets suit a band trading approach. Look for prices to get to the edge of the band, fade, then move back towards the opposite edge of the band.
In a sideways quiet market type the bands contract and the price forms a tight range. Many traders find sideways quiet market types difficult to trade, but they can be very lucrative if you are patient enough to wait for the eventual break-out. Alternatively you could go down to a lower timeframe and apply a band trading approach.
Trade What’s In Front Of You
Instead of focusing your time on hunting for a unicorn — a trading strategy that performs well in every market type — you could take a more practical approach: create a method to identify market types and build a set of systems that apply simple low risk/high reward trading strategies to each market type.
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