Wednesday, December 28, 2011

The Secret to Making Money Trading in 2012... and Beyond

Statistically, trading may be one of the most difficult ways to make money. In fact, it's estimated that up to 90% of traders lose money. That's a shame, since there are several simple trading systems that trounce the market.

Unfortunately, not all traders are ready to take advantage of winning trading systems. They require patience.

Major trends, the type that create real wealth, take time to develop. Traders that get caught up in the day-to-day market volatility miss the biggest market moves. Some of the best trading systems in world help traders ignore market noise while gains build up in their account.

The ten-month moving average trading system, for example, has consistently beaten the market and reduces risk over the long term. This simple trading strategy is long when the closing price of the market, or any security, is above the 10-month moving average and in cash whenever prices close below the average. If we apply a 10-month moving average to the S&P 500 Index since 1961, this easy to follow system beats buy-and-hold while reducing risk.

Risk is reduced by getting out of the market before major bear markets take back bull market profits. As the market turns down, prices fall below the 10-month moving average and trigger a sell signal. Impatient investors looking for an edge might try a 10-week or even a 10-day moving average to get "buy" and "sell" signals before other traders. That's a mistake. Test results show that the shorter moving averages actually reduce profits and increase risk over the 50-year test period:

Profits come from the big trends and weekly or daily moving averages give too many false signals. Prices often move quickly above and below short-term moving average, generating a series of small trades. These small trades are known as whipsaw trades, and they destroy returns. Trading with monthly moving averages reduces whipsaw trades and delivers bigger gains.

The chart below shows the difference in trading activity between the 10-day and 10-month moving average during the past 6 months. Trades are taken each time prices cross through the moving average.

During the past 6 months, the S&P 500 is down about -6%. Trading the 10-day moving average would have lead to 16 trades for a loss of about -8% -- worse than just holding the S&P 500. The 10-month moving average would have generated only two trades, for a small loss of less than 1%.

This simple observation led me to discover my own long-term profit machine - the 6-month rate of change (ROC) system. My system signals me to buy the best performing assets from the past six months. In the long-term, my system works very well -- it has delivered an average annual return of +14.9% since January 2007. The S&P 500 is barely breakeven in the same time period.

Trying to gain an edge by using a shorter term rate of change trading systems eats away profits. A 13-week ROC system, for example, would have lost -3% a year, a drastic drop from +14.9% annual returns with a 6-month ROC system. The reality is long-term winners are more reliable performers than short-term high fliers.

Right now, my system is signaling for traders to be patient. It's still holding three bond ETFs -- iShares Lehman 7-10 Year Treasury (IEF), iShares Barclays 20+ Year Treasury Bonds (TLT), and iShares iBoxx Investment Grade Corporate Bonds (LQD). These "boring" bond funds have significantly outperformed the market during the past six months. TLT is up more than 20%, IEF is up 9% and LQD has gained 2%.

The S&P 500 is down about -6%.

As I mentioned last week, my trading system has a great track-record trading bonds. So I have no problem holding bonds until my system says it's time to buy riskier assets. I recommend traders looking for big, long-term gains also be patient.

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