Stocks & Commodities V. 24:3 (30-37): Understanding Market Structure by Paolo Pezzutti
Understanding the market before placing your trade can make a huge difference to your trading performance.
Different financial markets have different behaviors.
This is because of the intrinsic characteristics of these markets (growth/value stock, for example), market liquidity, participants (long-/short-term investors, institutions, daytraders, and position traders), and
factors that affect the markets when market players elaborate information. You can make your system/method work under the technical conditions
that best fit the logic of the market if you understand the market structure. Ideally, you want to let your system/family of systems work only in environments
that maximize their performance. For example, running a short-term system on a market with a low daily range
would probably not be profitable after commissions and slippage.
THE STATES OF THE MARKET
The first step is to identify the state of the market so that you trade only when specific conditions are met. You can do that by applying a filter, but before you do so, letís try to conceptualize the subject. The main components of price movement are directionality and volatility. Volatility can be defined as a measure of an assetís tendency to move up and down in price over the latest n periods. Directionality can be defined as a measure of an assetís tendency to move along a defined trend. By combining these elements, you can come up with four market states...