The first step in developing a trading strategy is to select the market action and corresponding strategy type that you want to trade. As I've discussed, selecting a strategy type is a very important part of strategy trading and you should take your time in evaluating the alternatives. Many factors will influence your decision, but your own personality will ultimately direct you to the strategy that is right for you. In making the choice, the most important thing to remember is that it is yours to make alone. Read everything I have to share with you about different types of strategies, but then decide for yourself. Only you really know what type of person you are and therefore what type of trading is best for you. This chapter will help you to understand some of the conditions that can occur in the market, and the strategy type that complements those conditions. Once you are familiar with the basic strategy types, you will be able to select the one you want to use.

Three Market Types

Generally, there are three types of markets. The three market types, or phases, are derived from three distinct chart patterns that appear when there is a shift in market action. The phases are trending, volatile, and directionless, and each can be characterized by specific price activity. Take a look at the following charts and familiarize yourself with each different market pattern.

TRENDING MARKET
A sustained large increase or decrease in price characterizes a trending market. Take a look at Chart 1. This weekly chart of Coca Cola (KO) from early to mid-1997:

Chart 1 TradeStation EasyLanguage Indicator: Moving Ave Cross Input: Price(Close),Length1(9),Length2(18); Plot1(Average(Price,Length1),"SimpAvg1"); Plot2(Average(price,Length2),"SimpAvg2");

In fact, this stock has been in an up-trend since 1994. KO has almost tripled since then. This trending market was characterized by sustained up moves with very small and short-lived corrections. The 9- and the 18-period moving averages are included in Chart 1. A trend trader would buy the market when the shorter 9-period moving average crosses above the 18, and hold the stock until the 9-period average crosses below the 18. In this time period, he would have held KO for at least two trend moves.

Now take a look at this daily chart, Chart 2, of the Swiss Franc from mid-1996 to early 1997:

Chart 2 TradeStation EasyLanguage Indicator: Moving Ave Cross Input: Price(Close),Length1(9),Length2(18); Plot1(Average(Price,Length1),"SimpAvg1"); Plot2(Average(Price,Length2),"SimpAvg2");

In this time period, the Swiss Franc has been in a daily downtrend for many months. It has lost more than 15% of its value over the period. This market was characterized by a sustained downmove with very small corrections. The same moving averages were plotted here, the 9 and 18. Note that if you had followed these averages, you would have stayed short for several months at a time. The time frame you are looking at is important when you consider the type market action. Chart 3 shows the same Swiss Franc viewed on a monthly instead of daily chart.

Chart 3 TradeStation EasyLanguage Indicator: Moving Ave Cross Input: Price(Close),Length1(9),Length2(18); Plot1(Average(Price,Length1),"SimpAvg1"); Plot2(Average(Price,Length2),"SimpAvg2");

The downtrend in 1996-1997 looks a little different when put in this perspective. It looks like the most recent move in a directionless market. And if you had traded the same moving averages on Chart 3, you would have been chopped around and most likely lost a lot of money. The point is that you should be aware that a directionless monthly or weekly chart might have very tradable daily trends, and vice versa.