Prior to jumping into a financial market, an investor should be aware of the many different types of market conditions that exist. The goal of this article to inform a prospective trader of the different types of market conditions, and how to recognize what kind of market condition you are in, and when it changes.
Financial markets move in many directions. Sometimes, the markets trend in one particular direction over a short or long period of time. Other times, the markets stay in tight ranges without moving in a defined direction for a long period of time. There are times that the financial markets are very choppy, and move back and forth without moving anywhere. There are also times the markets are extremely volatile and move in one direction very quickly. Evaluating the particular market condition can be the different between a successful trade and a losing trade. Market conditions are a function supply and demand of a financial instrument. If demand for a product grows continuously, markets will move higher, on the other hand, if supply of a product out ways demand, the financial product will fall.
A trending market is a market that moves in one direction over a period of time. A market trend is a putative prevailing course or tendency of a financial market to move in a particular direction over time. These trends are classified as secular trends for long term time frames, primary trends for mid-term periods, and secondary trends lasting short times. Traders and analyst will use specific types of technical analysis to determine if the market is trending. When a financial instrument is trending higher, the market is called a bull market trend. When a financial instrument is trending lower, the market is called a bear market trend. There are many different types of technical indicators used to determine if a market is trending or beginning a trend. In the chart below, the Gold Spot market looks like it began its trend when the 20 day moving average crosses above the 50 day moving average in June. The market will stay in a trend as long as it stays above its medium/long term moving average. Shorter moving averages are better suited for identifying short term trends, while longer moving averages are better suited for identifying longer term trends.
Range bound markets
When a financial instrument moves up and down in a tight range, it is known to be range bound. When a financial market is in a bull or bear trend, it can experience times when they becomes range bound waiting for some news or impetus to push it higher or lower. When markets reach the end of a trend, they often become range bound as some traders who where long during the bull trend exit the market, but there is not enough demand for the financial instrument to push prices higher. This also occurs at the end of bear market trends. Range bound markets occur when supply and demand for a financial instrument is equal. The noise the market creates will push a market higher and lower during the course of a day, but without any impetuous to push demand higher or lower, the markets will stay in a range. Similar to finding trends, technicians will use specific types of technical analysis to determine if a market is in a range. The Bollinger Bands are a specific type of technical indicator that market technicians use to determine if a market is stuck in a range. The Bollinger Band indicator analyzes price data and create a 2 standard deviation range around a 20 day moving average. As the Bollinger Bands contract and move toward each other, the range of the underlying price of the financial instrument becomes tighter. When looking at the range that existed from mid 2007 to mid 2008 on EUR/JPY, a trader might come to the conclusion that the current range might last another few months (since the Bollinger range lasted approximately 12 months in the 2007 – 2008 period).
When a financial instrument moves quickly in one direction, the markets are deemed to be volatile. Volatile markets create trading opportunities, but they can also be very difficult to trade. Markets can also be volatile and choppy where, on an intra-day basis, the range of a financial instrument is very large, but the movement from the close on 1 day is small compare to the prior day. When markets are volatile or choppy, market participants are unsure of the direction of the market and therefore, this uncertainty creates large swings and volatility. One way traders and analysts measure if a market is volatile or going to be volatile is to look at a financial market that depicts volatility. The VIX, which is a volatility index, is a measure of how volatile the market is now, and how volatile it was in the past. The VIX Index is created by looking at the value of implied volatility that is priced into S&P 500 “at the money” options. By looking at a chart of the VIX a trader can see when the S&P 500 was volatile and what traders are currently expecting. When volatility is high, traders are expecting the market to move very quickly in one direction or another. When volatility is low, traders perceive that the market will remain subdued. Trending markets, especially bullish trending markets generally have low volatility, while choppy and quick bear markets, usually display high VIX levels. When looking at the chart below, the large selloff in the global equity markets, beginning in mid 2008 and ending in March of 2009, coincided with a large move in the VIX to a level above 80. Since March of 2009, as global equity markets rallied, the VIX returned to levels in the mid to low 20’s. The VIX is also known as the fear index, because high levels of fear coincide with a high level on the VIX. As investors look to protect their portfolios which put options on the S&P 500 Index, the price or value of the options increase, which increases the level of the VIX index.
Market conditions will always continue to change as participants find out new information about specific financial instruments as new information becomes available. By examining the type of market a financial instrument is currently experiencing, a trader can determine the type of position he would like to take.