Extracted from the book: Trend Trading for a Living, Thomas K. Carr
Five different types of market conditions
- Bullish strongly trending
- Bullish weakly trending
- Bearish strongly trending
- Bearish weakly trending
- Range-bound (or nontrending)
BULLISH: STRONGLY TRENDING
The Focus: It should be on long setups, particularly breakout plays.
Characteristics: Everything goes up, and up a lot, nearly every day. The bulls are completely in control and win every battle with the bears. Making money is easy in a bullish strongly trending market, as long as you have the right entry system. But the drawback is that when this kind of market reaches a top, the sell-off can be quick and harsh and can wipe out months of hard-won gains in a matter of days. So in a strong bull market you must always be careful to play defensively against a possible reversal of momentum.
How to Play It: Here we can say that a bullish strongly trending market is a great market to be in if you are already long. But if you are coming late to the party (and hopefully not too late), your best play is to look for stocks that are breaking out to new highs from periods of consolidation. You must make sure these breakout plays are confirmed by the various technical indicators we use. If price is making a new high but the indicators are not making new highs, then you have bearish divergence and you should move on to another chart.
BULLISH: WEAKLY TRENDING
The Focus: It should be on long setups, particularly pullback plays.
The Focus: It should be on long setups, particularly pullback plays.
Characteristics: This is a tougher market to trade, since the pullbacks tend to be more frequent, steeper, and
longer-lived. In a weakly trending market, corrections can last a couple of weeks. This can be frustrating if you are sitting on open long positions. Ultimately, the bulls are in control, but it can seem for days on end that the bears have moved in and made themselves right at home. However, this is one of the best markets in which to find great risk/reward scenarios in our setups. Those lengthier pullbacks serve to take a lot of the risk out of a trade, so our stop-loss can be closer to entry, and our exit targets can be that much further away.
How to Play It: Here we can say that a bullish weakly trending market is an ideal market for trend trading. You should find stocks that are showing strong trending action (normally stronger than the general market itself ) but have pulled back to an area of support. This pullback should be confirmed by oversold indicators, and the current daily candlestick should put in a reversal bar of some kind before you consider an entry.
BEARISH: STRONGLY TRENDING
The Focus: It should be on short setups, particularly breakdown plays.
Characteristics: This is perhaps the most difficult market to trade. There are two reasons for this. First, bear
markets always fight the long-term trend of the stock market (which is up) and, as such, tend to be short-lived. The second reason has to do with the extremely volatile nature of short-covering. Strong downtrends can cause a market to get so oversold so quickly that automated buy programs kick in to scoop up cheap shares. This causes traders and fund managers to cover their short positions in order to lock in profits. As they do so, they are forced to buy back shares they have borrowed, and the result is a sharp and quick short-covering rally (what traders call a dead cat bounce). But the advantage of bearish strongly trending markets is that they tend to go down faster than bullish strongly trending markets go up. When the bears are in control of a market, as they are in this type of market, they tend to go wild and overdo things. Can you blame them?
For over 200 years, they have had to play second fiddle to the flashier bulls, and finally this is their chance in the spotlight. But you can take advantage of this. If you are willing to play the short side—to trend-trade for a living you must be willing to short—you can potentially make a lot more money in less time in a bearish strongly trending market than in any other type of market. And it is always a thrill to make money while 90 percent of the investing world is losing theirs.
markets always fight the long-term trend of the stock market (which is up) and, as such, tend to be short-lived. The second reason has to do with the extremely volatile nature of short-covering. Strong downtrends can cause a market to get so oversold so quickly that automated buy programs kick in to scoop up cheap shares. This causes traders and fund managers to cover their short positions in order to lock in profits. As they do so, they are forced to buy back shares they have borrowed, and the result is a sharp and quick short-covering rally (what traders call a dead cat bounce). But the advantage of bearish strongly trending markets is that they tend to go down faster than bullish strongly trending markets go up. When the bears are in control of a market, as they are in this type of market, they tend to go wild and overdo things. Can you blame them?
For over 200 years, they have had to play second fiddle to the flashier bulls, and finally this is their chance in the spotlight. But you can take advantage of this. If you are willing to play the short side—to trend-trade for a living you must be willing to short—you can potentially make a lot more money in less time in a bearish strongly trending market than in any other type of market. And it is always a thrill to make money while 90 percent of the investing world is losing theirs.
How to Play: Here we can say that a bearish strongly trending market is a great market to be in if you are already short. But if you are coming late to the party (and hopefully not too late), your best play is to look for stocks that are breaking down to new lows from periods of consolidation. You must make sure these breakdown plays are confirmed by the various technical indicators we use. If price is making a new low, but
the indicators are not making new lows, then you have bullish divergence and you should move on to another chart.
BEARISH: WEAKLY TRENDING
The Focus: It should be on short setups, particularly rallies into resistance.
Characteristics: This is an easier bear market to trade than the strongly trending version, since the rallies into
resistance that trigger our setups take a lot of the risk out of the trade. But it still suffers from the two problems associated with bear markets we mentioned previously. In a weakly trending market, corrections (rallies) can last a couple of weeks, which can be frustrating if you are sitting on open short positions. Ultimately, the bears are in control, but it can seem for days on end that the bulls have moved in and made themselves right at home. However, just like its bullish cousin, this is one of the best markets in which to find great risk/reward setups. Those lengthier corrections to the dominant trend serve to take a lot of the risk out of a trade, so our stop-loss can be closer to entry, and our exit targets can be that much farther away.
How to Play: Here we can say that a bearish weakly trending market is a good market for trend trading. You should find stocks that are showing strong downwardly trending action (normally stronger than the general market itself ) but have rallied up into an area of resistance. This rally should be confirmed by overbought indicators. The daily candlestick should put in a reversal bar of some kind before you consider an entry.
RANGE-BOUND (NONTRENDING)
The Focus: It should be on both long and short setups, particularly trendline breakout/breakdown plays.
Characteristics: Range-bound markets are the bane of a buy-and-holder’s existence, but for the technical trader they are a godsend. This is because the technical indicators we use (stochastics, CCI, RSI) register overbought and oversold signals that work most robustly in range-bound markets. Moreover, if you are willing to trade more frequently, you can make a lot of money in a range-bound market. It is essential therefore to learn how to identify range-bound markets, because the general market spends a majority of
its time in such a condition. In a range-bound market, price bounces up and down between roughly parallel pivot points of support (on the low side) and resistance (on the high side). Such a market suggests that bulls and bears are waging a war with each other, but no one side is clearly winning. Trading ranges between parallel pivot points can be either wide or narrow, and it is a general rule that the wider the trading range, the longer price stays within it. Narrower ranges tend to be broken to the upside or downside more easily.
How to Play It: Here it can be said that it is frustrating for traders when a range-bound market first appears, especially when it follows a strong up- or downtrend. Traders can be reluctant to transition from a fast-money, momentum environment (strong trend) to the more strategic, labor-intensive environment of the range-bound condition. But once the trading range is established, it can be an ideal trading environment. In a
trading range, we use trendlines to highlight and delimit the minitrends within the range and our technical indicators to spot oversold and overbought levels as well as bullish and bearish divergence. We are looking to play reversals right off the pivot points of support and resistance, confirmed by a break of the intrarange trendline. Indicator divergence is often a key to locating the best reversal trades and will often let us pinpoint with extreme accuracy the tops and bottoms of movements within the range.
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