Understanding Market Conditions

Understanding the overall market condition when trading is one of the most important aspects of trading. 

Many traders fall into the trap of not knowing when to scale back their trades. Trading aggressively in a volatile market like right now can be psychologically challenging. This may ultimately lead to discipline issues.

So how do you determine when is the right time to scale back your trades?  

The answer is Market Timing.  

Market timing is one of the Master Keys in the WiseTraders trading system.  At WiseTraders, we only trade in optimal market conditions, either bullish or bearish.  That means scaling back when markets are choppy or news-driven. 

Analyzing Market Conditions

Many traders use multiple technical indicators to analyze the overall market conditions. Common indicators used are the relative strength index (RSI), stochastic oscillator, MacD, Fibonacci, and many more.  Unfortunately, these indicators can be illogical, invalid, and highly subjective as they are based on the trader’s assessment of where the price is currently trading relative to prior prices. 

At WiseTraders, we use our proprietary OVI indicator, the longer term OVI Sentiment Indicator (OVIsi), and other Market Timers to analyze the overall market condition. These indicators help us identify what the overall market sentiment is, based on the logic of supply and demand, which is the number one factor that moves prices in the markets. This allows us to adjust our trading plan and strategy according to prevailing market conditions.

Identify the Different Market Conditions

A tradeable market can typically be broken down into four main conditions:
  1. Oversold
  2. Bullish
  3. Overbought
  4. Bearish

Oversold Market Condition

Oversold conditions typically occur after a trending market experiences a pullback towards a Key Level (50 or 200 day-moving average).  Note the word “trending” here.  During choppy conditions, bouncebacks off Key Levels do not carry the same probability.

Notwithstanding this, markets can remain oversold for a long time. That means being oversold does not guarantee that a price rally will occur soon. It is always best to wait for a consolidation and an upward breakout instead of the typical “buying the dip”. 

The term “oversold” can also be highly subjective if you’re using different tools to analyze the overall market condition. Some traders may see an oversold market while others may see a market that has further to fall. Therefore, it’s important that you pick a trading system that analyzes the market in a logical way. 

Trading an Oversold Market

If the medium term trend is still upward, traders should typically focus on trading bullish setups where the stock is short term oversold. It is dangerous to go aggressively short when up-trending markets are oversold because the potential for a price bounce is high in such market conditions, which are ideal for short squeezes. Being aggressively short here may result in margin calls if the markets make a dramatic recovery. 

Short term oversold in a medium term rising market also offers great buying opportunities to long-term buy-and hold investors. This is because those stocks could be deemed to be trading at a discount. 

At WiseTraders, we focus on swing trading which is a shorter-term strategy ranging from days to weeks, and sometimes even months if there is a sustainable trend to latch onto. We filter for stocks that are consolidating around a key level (50 or 200 day-moving average) in order to control our risk on any trade. 

These consolidations should typically be accompanied by evidence of bullish ‘Big Money’ activity (a blue OVI reading among other indicators). This increases our probability of winning if a breakout does occur. 

Notwithstanding this, markets can remain oversold for a long time. That means being oversold does not guarantee that a price rally will occur soon. It is always best to wait for a consolidation and an upward breakout instead of the typical “buying the dip”. 

The term “oversold” can also be highly subjective if you’re using different tools to analyze the overall market condition. Some traders may see an oversold market while others may see a market that has further to fall. Therefore, it’s important that you pick a trading system that analyzes the market in a logical way. 

Bullish Market Condition

Bullish conditions occur when prices are rising. Markets start marking higher lows and higher highs here. This will lead to an up-trending market. 

Bull markets have historically lasted around 10 – 11 years. They generally take place when the economy is strengthening or when it is already strong. Investor confidence is high during this period. And the overall demand for stocks is mostly positive. 

Markets tend to trade around their 20 or 50 day-moving averages when a retracement occurs in a strong bullish market. A pullback towards the 200 day-moving average would most likely lead to oversold conditions and a quick recovery if the overall market remains very bullish. 

Trading a Bullish Market

Bullish market conditions are generally easier to trade as confidence is high. Traders should focus on bullish setups here as this will allow you to ride on your windfall winners. 

There may still be several shorting opportunities in a bullish market. However, the reward potential for these trades will generally be lower. Any pullbacks that occur in a strong, bullish market tend to be short and temporary. This generally leads to smaller wins on short trades.  

Ultimately, it makes sense to swim with the tide, not against it.  

The profit potential on a bullish trade is much higher in bullish market conditions as the probability of the stock rising to a new all-time high is much higher. But it is important to not chase after a stock that has risen parabolically. Remember to always wait for a tradeable setup to form before buying into a stock.  

At WiseTraders, our preferred trade setup is the consolidations/flags that are accompanied by evidence of bullish Big Money activity (a blue OVI reading).

Overbought Market Condition

Overbought conditions typically occur after the markets experience a parabolic rise – often towards a new high. The markets will generally be trading very far away from their key levels (20/50/200 day moving average) here. The potential for a price correction from these levels is high.

Overbought conditions are caused by buying pressure. Excess buying pressure will lead to continued upward pressure in the markets.  At some point the buyers evaporate, while others seek to take profits. This leads to other traders betting on a potential reversal in price, hence a steep retracement may occur.    

Markets can remain overbought for a protracted time. Where there is no selling appetite you will observe price drift for weeks or even months, before they reacquaint with a Key Level.  

In this way, overbought does not guarantee that a dramatic price reversal will occur soon or at all.  

Trading an Overbought Market

Traders should typically avoid overbought stocks and wait patiently for a tradeable setup to occur.  

It is dangerous to go aggressively long when markets are overbought because of the higher potential for a price correction. Being aggressively long here may result in all your stops being triggered simultaneously if the markets make a dramatic pullback. 

Overbought stocks do present interesting trading opportunities, however.  

Two strategies to consider are the straddle and the bear call spread.  

In the event of a dramatic pullback the straddle will fair well.  

In the event of no new highs being made the bear call spread will do well.

Bearish Market Condition

Bearish conditions occur when the markets experience a prolonged decline. Markets start marking lower lows and lower highs here. This will lead to a down-trending market. 

Theoretically, bear markets are associated with an overall decline of 20% or more off a recent all-time high. They are generally followed by an economic downturn such as a recession. And the overall investor sentiment is mostly negative. 

It is normal for markets to trade around or below their 200 day-moving average. A price bounce off a support level or an oversold level may result in a dead cat bounce when markets are very bearish. Therefore, it’s best if traders focus on the bearish setups here. 

The reward potential on a trade will always be higher when you trade in line with the overall market condition. That means going long in a bullish market and short in a bearish market. 

Trading a Bearish Market

Bearish market conditions are generally trickier to trade as they are more volatile. More experienced traders who wish to trade in this market condition should typically go short when the markets or the stock breaks below a support level. 

Short-selling a stock involves borrowing shares from a broker before placing a short-sell order. This will result in a margin requirement that will vary across the various brokerages. It can be very risky and can cause heavy losses if you do not manage the trade properly. Therefore, you must remember to protect your profits and only trade within your own risk tolerance level. 

If you’re not comfortable with the short-selling strategy, it’s perfectly okay to sit on the sidelines or switch to paper trading to build trading confidence. Options are also another great alternative which will allow you to short stocks without any margin requirement. 

PS. If you’re interested in any of our OVI trading services for stocks or options such as a fast-track mentorship or workshop event, book yourself an appointment here to speak with us. Many of our members aren’t aware of all the services we offer to help you become an established consistent winner with the OVI. Remember, everyone is an individual, and we ensure that we can cater to you and your particular needs.

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