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Thursday, March 21, 2013 - 06:00

The Simplest Way to Avoid the Market's Next Major Downturn

Thursday, March 21, 2013 6:00 AM

A complete trading system can be defined with detailed buy and sell rules. That's all you need to have a system. Rules let traders know what they should do in advance.

Disciplined traders follow their rules and avoid making emotional decisions in fast-moving markets.

Two simple ideas -- trading rules and the discipline to follow the rules -- can help you avoid large losses.

Trading systems can be as complex or as simple as you decide they should be. For example, a system could trade based on a moving average (MA) and sell all stocks whenever SPDR S&P 500 (NYSE: SPY) falls below its 10-month MA. This simple rule would help you avoid large losses in bear markets, but you would often miss a large part of the eventual recovery waiting for the buy signal. That makes a 10-month MA system difficult to follow.

The rules guarantee delaying buys in bull markets, so traders often adapt by adding rules to simple systems. In this example, it might be better to buy when SPY closes above its six-month MA while keeping the 10-month MA as the sell rule.

We now have the complete rules for a trading system:

-- Buy SPY when it closes above its 6-month MA.
-- Sell and hold cash when SPY closes below it 10-month MA.

With these rules, you know exactly what to do in any situation. If the market drops suddenly, but remains above the 10-month MA, you hold your stocks. Once it falls below that average, you are a seller.

Trading signals are shown in the chart below with green arrows showing buys and red arrows indicating sells. The chart is simple with a black line for closing prices, a solid red line for the 10-month MA and a green dashed line for the 6-month MA.

It catches every big trend, which is all the system is designed to do. There are a few small trades, but for the most part, this looks like a successful strategy.

You could trade this system using the information found on a number of websites and would not even need to learn how to program the rules. If you did want to program your own rules, trading systems can become more complex and the potential number of rules you can use becomes unlimited.

More rules might not always make better systems. I spent 20 years in the U.S. Air Force working with nuclear missiles and other incredibly complex systems. I was always taught that given two options, pick the simpler one. There is less chance of error with simple solutions, and errors in that environment can have what we called "catastrophic consequences."

Adding complexity usually leads to a system that works perfectly in the past but breaks down in the future. For example, we could add breadth divergences, momentum breakdowns and time filters to the simple MA system shown above. They would perfectly define the conditions that existed before the 2008 crash but would miss the 2000 crash. They would also probably miss crashes awaiting us in the future.

One reason traders add complexity is because they believe that trading must be difficult. They are right -- it is difficult to understand what indicators add value to a system and it is difficult to follow the rules with discipline. But simple ideas work well for trading systems. In addition to moving averages, relative strength (RS) works well and even chart patterns can be the basis of profitable trading systems.

A chart pattern, such as selling when a head-and-shoulders pattern appears on a chart, could be successful if the analysis is applied consistently and every trade signal is taken. Automated trading systems based on indicators are generally easier for traders to implement but some traders may find that patterns work if they have time to review the charts every day.

Every mutual fund investor has read that "past performance is not a guarantee of future performance," and that applies to trading systems as well. The future will not be exactly like the past but the past offers clues to what we should see in the future. If the logic behind the rules is sound, as it is in the moving average example, the system should work in the future if it worked in the past.

Action to Take --> Consider developing a trading system that will allow you to take advantage of market moves and avoid most of the losses that will come in the next bear market. When building your own system, remember that more complex systems are not necessarily better. The best trading system to use is one that you understand and have the time to follow.

This article originally appeared on ProfitableTrading.com:
The Simplest Way to Avoid the Market's Next Major Downturn

Note: I just finished reading a special report published by my colleague, Amber Hestla-Barnhart. The report details how to consistently and reliably pull income from the options market. It's Amber's one-of-a-kind training as a military intelligence analyst that allows her to see things others miss. It's something I think you should see. If you're interested, you can see the report for free when you click here.

Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.