Learning to Trade 103

Trading can be simplified to a number of decisions that do not need to be made simultaneously. For example, one can distill the buying decision into what to buy and, later, when to buy it. Once bought, the decision becomes when to sell it. By constructing rules, one avoids emotionally poor decisions of trading without a system. Rules give one a trading system that can be backtested to determine profitability and potential risk.

What to buy can be simplified by only trading Exchange Traded Funds (ETFs). These come in pairs, so when the market are going up, one can buy a bull-market fund, and conversely, when the markets are going down, purchase the bear-market funds. By purchasing a fund representing a wide-range of stocks, one has handled concerns of diversification without having to think about it.

For example, use SSO and SDS, which represent the 500-largest capitalized stocks of the stock market. During market appreciation, own SSO; during market declines, own SDS. The question then becomes: How does one know when to sell one and buy the other? A simple manner would be to use some indicator that would tell you mechanically when to switch. Using two moving averages was discussed in a previous entry, Personal Finance 101. This system provided a 38% average annual return including through the otherwise bad year, 2008. Not bad.

An even better way was covered in Trade Switch, posted March 23, 2009. This system uses QLD and QID, ETFs using the 100-largest capitalized stocks of the NASDAQ. At the time of the switch, this system was performing per the attached graphic, or 131% per year--including the infamous year, 2008. That system switches when the New York Stock Exchange's accumulative 52-week Highs minus 52-week Lows, as measured weekly, reverses from positive to negative or vice versa. This is graphed here. Be sure to use the weekly graph, and use it after Friday's trading day has been posted. Otherwise, the latest week will only include week-to-date, not the entire week.

These two systems use ETFs that have existed since July 2006, allowing backtesting in both bull and bear markets. The new 3X ETFs did not exist then, but should perform even better. However, one is advised "test before using." Testing is often cheaper than reality.