From the April 2013 issue of Futures Magazine • Subscribe!

What’s your (market) type?

Observe, adapt

The reason so many speculators crashed and burned after the Internet bubble burst is they didn’t understand the importance of market types. What works during a parabolic market move, won’t work when the parabola turns downward. Unfortunately, many traders didn’t recognize the turn, or the sideways market that followed (see “Breakout!” below).

If more traders understood this concept, and reacted, they might have avoided the crash and instead adopted or developed tools that would have made money as prices churned.

But you can’t blame your average trader for missing the clues. We typically think of markets as “up” or “down” entities, with little consideration for time frame or directional movement across periods. This brings us to an important concept in recognizing the operative state of the market. If you change your point of reference, price trends take on a whole new shape.

Time periods generally are defined as follows: 

  • Long-term: A period of months to years.
  • Intermediate-term: A period of weeks to months.
  • Short-term: A period of minutes to days or weeks.

A critical rule when using time periods is that the larger time frame has dominance over the smaller time period when defining primary price movement.

So, by understanding time periods, you can define the period of price action to determine which market-type is in play. They are, simply: Up, down or sideways. Once you properly can identify the market type, you can tailor your approach for higher performance.

Warren Buffett’s style of value investing — described as “selective contrarian investing” in “The New Buffettology” — focuses on not just buying a stock on valuation but instead actively exploits bear markets as primary buying opportunities. For Buffett, the shift to a down market is a key setup for bargains to ultimately materialize. This market type is an important condition for maximizing returns.

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