A trader\'s money management system

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c06 JWBK182-McDowell April 25, 2008 15:54 Printer: Yet to come

Entry Rules and Your Trading System 51

identified that February is pretty darn cold, and to appropriately adapt you

will want to wear a winter coat and maybe gloves and ear muffs.

It is the same with the markets. You need to “live there for a while” and

experience a variety of market cycles so you know what to wear, or rather

how to adapt, so that you are financially comfortable. Instead of knowing

to wear a winter coat in February you will know that in a choppy, sideways,

bracketed market you need to adapt your system and rules so that you do

not get whipsawed and stopped out a lot. Or, you may need to recognize a

bull market changing to a bear market.

This is not a money management issue, but it is important in terms of

your profitability and will work in conjunction with your money manage-

ment. So, in addition to having a trading system you feel comfortable with,

you need to learn what the different market cycles are. Then you need

to learn how to correctly identify when the different market cycles are

occurring.

Finally, you need to learn how to adapt your approach to those cycles

to remain profitable. Effectively identifying market cycles is a skill that all

successful traders have mastered.

FOUR MAJOR MARKET CYCLES

There are four major market cycles. Each market cycle requires a differ-

ent approach from your trading system, and adapting to market cycles can

improve your profitability dramatically:

1. Trending.A market is moving consistently in one direction, up or
   down. (See Figure 6.3, which shows a bullish trend in crude oil.)


2. Consolidating.Also known as bracketing, this is when the market
   is stuck in a price range between an identifiableresistanceandsup-
   portlevel. On a chart, it will look like a sideways horizontal line. (See
   Figure 6.4, which shows a bracketed e-mini market. Notice how the
   triangles, potential pyramid trading points, tell you this is a bracketing
   market when they form directly next to each other in a “down” “up”
   “down” “up” sideways pattern.)


3. Breaking out of a consolidation.There is a sharp change in price
   movement after the market has been consolidating for at least 20 price
   bars. (See Figure 6.5, which shows the bracketed e-mini market you
   saw in Figure 6.4 break out to the down side. Notice how the two
   “down” pyramid trading point triangles from Figure 6.4 were confirmed
   and the two “up” triangles disappeared.)