The state of the market and its diagnosis

Master-class: Trading strategies in practice. Strategy 10

Studying stock trading and trading systems in particular, we are used to distinguish two states in the market: trend и Flat. Based on the knowledge of which of them prevails in the market, the trader makes a decision to "turn on" one or another system. Such as, trending - to work in the trend with wide stop orders or without them and with even larger Take Profits. Or countertrend - for work in the flat, triggered when the price approaches a significant level of support or resistance. Such a system assumes a relatively short StopLoss and TakeProfit, i.e. exiting the market when the price approaches the opposite border of the flat.

However, in reality it does not look that simple. Very often even trading in the trend, the trader suffers losses on the deep pullbacks, and a wide enough flat can easily develop into a trend with the breakdown of one of the boundaries. Therefore, in order to avoid unnecessary losses it is advisable to determine the market condition not only from the point of view of a "trend-flat", but also to measure the strength (volatility) of this trend or flat.

Market conditions

The different states of the market have been well described in the book "The Way of the Turtle" by Curtis Feiss, so we are not going to invent anything new in this article, we will use them. According to Feiss, the market is in four states:

1. flat calm: Prices are in a relatively narrow corridor without any sharp moves beyond its borders;
2. trendy calm: calm price movement for a long time in one direction without significant pullbacks or movement in the opposite direction;
3. flat volatile: The price moves with large swings, but there is no forward movement up or down over time;
4. trending volatile: The price is moving in a strong trend with very deep pullbacks, similar to a change in trend.

Now it is clear why even in a trend there are losing trades

In determining the state of the market (or in making a diagnosis) we will operate with two concepts, based on the 4 states of the market, are direction и volatility.

To determine both direction and volatility, quite a few tools have already been invented, so we will turn to the simplest ones. We will measure the direction of the trend with ADX (Average Directional Movement Index) indicator - The intersection of +DI and -DI will indicate the direction, and the ADX curve will additionally show the strength of this trend.

ADX indicator work

Already by one ADX indicator You can make a diagnosis and make the right decisions both in a broad trend and in a broad flat. Below is an example of how to assess the trend direction and its strength on a 5-point scale.

Estimates for the up trend:

- +DI up, -DI down, ADX up = 5;
- +DI up, -DI down, ADX down = 4;
- +DI down, -DI down, ADX up = 3;
- +DI down, -DI down, ADX down = 3;
- +DI down, -DI up, ADX up = 2;
- +DI down, -DI up, ADX down = 1 (until two DIs cross).

It is applied mirrored to the downtrend.

ROC indicator operation

Also to determine the strength of the trend it is proposed to use a very sensitive ROC (Rate of Change) indicatorwhich calculates the change of the current price from the price of n periods ago. On the ROC itself in the indicator window are thrown Bollinger BandsThe distance between them accurately indicates the strength of a trend or a flat, i.e. is responsible for the "calm/volatile" component (see Fig. 1).

Fig. 1. GBP/USD, H4. Application of the indicators.

Parameters indicatorsROC - 4, Bollinger Bands - 7, ADX - 6. The parameters were purposely chosen to be very sensitive because the market Forex is no longer one for which classical indicators with very large parameters would be useful: trends change too often and do not allow for a long stay in the market without serious losses.

The calm trend on the indicators is characterized by narrow Bollinger Bands on Rate of Change (see Fig. 1, plot 1) and a pronounced downtrend on the ADX, where the ADX curve itself also signals a steady trend. In the second plot we see a volatile trend: the Bollinger Bands are diverging, the ADX is rising and indicating a downtrend. In the third plot we see a volatile flat with a large distance between the Bollinger Bands on the ROC and clear indications of a flat on the ADX - both DI lines often overlap and the ADX itself is declining.