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Trading as a Business:
Markets, Strategies, & Time Frames (cont.)
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.
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
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
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