"Market Quality" Concept With Market Internals

In today's article, I would like to share with you a construct that I have given to some of my students. It's a pretty simple, yet powerful construct on how Market Internals can be used:

Take an existing Market Internals, let's say NYSE TICK.

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Use NYSE TICK to define market "quality" zones: non-trending, trending, and strongly-trending.

By doing this, we have created 3 different zones of quality for this given market, which I will call "Market Quality" (MQ).

For each MQ zone, we can either set up different risk exposure/numbers of contracts or even switch between different trading strategies.

Let's get a load at an example:

If we use NYSE TICK (this MQ construct can be applied to all other Market Internals, anyway), then the initiative is to specify the zones as non-trending, trending, and strongly-trending.

According to my experience, the limit when a non-trending market changes to a trending one is at 300 to 400 for a long position, and -300 to -400 for a short position. Then, we need to set up the limit in which trending goes to strongly-trending, which is, supported my experience, someplace at about +1,000/-1,000.

The definition of these 3 different MQ zones, when using TICK NYSE, looks like this:

LONG:

Non-trending: 0 to 400

Trending: 400 to 1,000

Strongly trending: above 1,000

SHORT:

Non-trending: 0 to -400

Trending: -400 to -1,000

Strongly trending: below -1,000

Now, when we have defined the different zones for market quality (MQ), we need to ask ourselves,

what do we do with this information

? And there are two viable options.

The first one is risk management, or ever-changing the number of contracts.

You simply test the number of contracts (1-3 or 0-2) for each zone and see how your system behaves when you use a different number of contracts, according to the MQ zone you are in. In this same way you can work, not only with the number of contracts, but also with your stop-loss. It is clear that each zone represents a different volatility and, therefore, using different stop-loss levels for each MQ zone can bring absorbing results.

This is one of the basic applications of the MQ construct (it can be further developed into a more sophisticated form).

The second option is using MQ zones to switch the systems - something like this:

Switching systems supported Market Quality zone:

Non-trending: scalping system

trending: trend-following system

strongly trending: mean-reversion system

For non-trending market conditions, you will simply use a scalping system that doesn't need big moves for profits. As soon as the Market Quality changes to a trending market, you will switch to trend-following strategies (for example a break strategy). And, as soon as the market reaches a certain level, when the trend power be reaching its end (when NYSE TICK gets above +1000/ below -1000), you should start looking some counter-trend entries (mean-reversion) strategies, that are waiting for a counter-trend correction after a significant market move (and you try to make some profit from this correction).

Using this approach, you will get one "universal" system that will change its settings according to the Market Quality. This is just a theoretical example - the application is up to you. And it is quite load of work to get from possibility to practice. So, let's get to it!

You can also work further on this construct, develop it to more forms and find other ways to use it - the example with TICK is just one of many ways in which Market Quality can be used. Or, you can use a "hybrid" of both these approaches - according to the MQ zone you can switch strategies, change your stop-loss, or perchance alter the number of contracts.

What I would do is keep the number of MQ zones low. 2-3 zones are perfectly enough - in the case of more zones, there is the risk that you could not have a comfortable number of trades in each sample.

Anyway, now you have a strong and absorbing construct, so roll up your sleeves and get to work!

Happy trading!