In addition to defining the market type of your primary time period, you also will want to make note of the market type of the time period one step higher. You will want both periods to align before you shift your bias. Likewise, once that bias has been set, constantly monitor both periods and once either breaks, prepare to transition from one market type to another. This preparation might involve liquidating positions, tightening stops or employing protective options strategies depending on your personal approach.
Keep in mind, however, that the shorter time period will lead the simple moving averages on the longer time period. However, this doesn’t necessarily mean that the two always will move in lock step. For example, the shorter time period might reverse temporarily before the longer time frame catches up.
For most traders, a shift in market bias is a signal to step back and reassess. However, aggressive traders will pounce on the market reversals — those that can appear at the point where market types shift — that can generate significant profits. Most styles, however, are more conservative and benefit from patience, consistency and caution. As with all strategies, approach market type changes in a way that is consistent with your risk tolerance; otherwise, you may lack the discipline to follow your strategy.
The ability to adapt to the market environment is necessary for financial survival. Fortunately, this is not a difficult task, but like most trading rules, it’s important to follow it consistently and precisely. Avoid over-complicating your analysis of the current state of the market. The rules reviewed here are a simple and effective approach and provide a clear visual signal of whether the market is moving up, down or sideways.
Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.