DIRECTIONLESS MARKET
A directionless market is characterized by smaller, insignificant up and down movements in price, with the general movement sideways. We probably would not call Chart 3 of the Swiss Franc directionless because the movements were not insignificant.

On the other hand, Chart 4 of Caterpillar in 1996 clearly shows a sideways directionless market, whose movements I would call insignificant, as the stock moved between 31 and 37 for most of the year. Markets chop around like this between trends. As you can see, I put the Stochastic Indicator on this chart. The Stochastic Indicator is commonly used as an overbought/oversold indicator. In directionless markets, you might attempt to buy CAT when the Stochastic is at or below 20 or 25 and sell when it is above 75 or 80. You could have made some money doing this with CAT in 1996.

Chart 4 TradeStation EasyLanguage Indicator: Stochastic Slow Input: Length(14),BuyZone(20),SellZone(80); Plot1(SlowK(Length),"SlowK"); Plot2(SlowD(Length),"SlowD"); Plot3(BuyZone,"BuyZone"); Plot4(SellZone,"SellZone");

VOLATILE MARKET
A volatile market is characterized by sharp jumps in price. Chart 5 is a weekly chart of American Software. You will notice that this type of market action involves a quick and unexpected change in volatility. At the marked points on this chart, AMSWA was quiet for the previous 7 to 15 weeks. Then the price leaped out of this low volatility trading range. This is what is commonly called a "volatility expansion."

Chart 5 Volatility Expansion Examples

The volatility of the market increased substantially during the breakout week as it shot out of the previous range. Strategies can be designed to take advantage of this type of change in volatility. They are generally called Volatility Expansion Strategies.

Volatility expansion strategies profit from market action like the movement depicted in the AMSWA chart. Basically, the strategy measures recent volatility and attempts to trade an immediate increase by buying an upside breakout with increased volatility or selling a downside breakout as the volatility increases.

Another measure of volatility might be the difference or spread between two moving averages-the spread increases with volatility. Price action, such as gap openings or an increase in the daily range, can also be considered an indication of an increase in volatility.

Three Strategy Types

Each of these three types of markets (Trending, Directionless and Volatile) are tradable, but with markedly different trading strategies. Let's take a look at each type of market behavior and the strategies that are appropriate to that type of market.

TREND FOLLOWING STRATEGIES
Like the name, trend-following strategies are designed for trending markets, and to take a position for all the big trending moves that may occur. In creating trendfollowing strategies, the number one priority is that the strategy must never miss the big move.

The easy way to accomplish this is to always be in the market, that is, to always be either short or long. If you always have a position, you will always be there when the big move takes place.

The other method is to always have a "stop" order in the market, resting either above or below the current price (this is the same order as a stop loss, but it is used to enter the market rather than exit). Using a stop to enter the market will protect you because if the market moves quickly in either direction, you will be stopped in before the big move begins.

I can't emphasize enough how important it is never to miss a big move in trendfollowing strategies. During the choppy, directionless phases of the market, you will experience several losses in a row and most likely significant drawdown.

Therefore, if your strategy misses a big move, you may not have enough capital to hold out through the drawdown for the next big move.

Another design priority should be to limit your losses during the market's sideways mode. Notice how I said limit losses not make profits. It is very important to recognize that no strategy will make money in every market condition. It is therefore very important to identify the market action in which the strategy will make money and the market action in which it will lose money.

Once you have found the market action in which the strategy will lose money, it becomes a strategy design priority to minimize losses during that market action. If the strategy is designed to make money in a trending market, it will lose money in the choppy phase. Your priority should be to minimize the losses in the directionless market.