The rules I’m going to share with you to help trade this market are all statistically backed. You only have to look at the investment results this year of the people who come onto television sprouting their views to know that most of their methodologies have no statistical evidence of working in a down market. Think back to 2000-2002. The same carnage that happened then is now being played out a second time in this decade. Markets go up, their funds go up. Markets get volatile and go down – these people are not equipped to handle it. The numbers and the results from 2000-2002 and again this year are the proof of this.
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So how do you make money in a market like this? The exact same way you make money in a rising market. You start with 5 simple rules and you do your best to abide by those rules.
We’ve been publishing these rules for years and it’s helped many of the long time customers who have been with us. And we do our best to live with them too. The rules not perfect (not even close) and they do not guarantee we or anyone else will make money in the future. But I oversee a private investment partnership which has been profitable since inception. And as of September 30, we’re again profitable this year. Why? Because of the following set of guidelines or rules which are the backbone of our trading.
I’ll share them with you and they’ll hopefully provide some guidance for your own trading.
Rule 1: Only buy stocks above their 200-day moving average.
This rule, more than any other, is the reason why people who use it have done well this year. If you go back to 1995 and look at every stock’s 5-day performance above their 200-day moving average versus below, you will see edges on the stocks that were above the 200-day (this is on a sample size of over 8 million trades). What the statistics don’t truly reflect though, is the wreckage many stocks below the 200-day moving average cause. Go look at the charts of Bear Sterns, Countrywide, Lehman, Wachovia, the mortgage companies, the home builders and many more and see what happened after they broke under the 200-day moving average. Nearly every money manager in the world could have protected their investors from this one simple rule. And you can too by simply avoiding stocks below the 200-day.
Rule 2: Buy stocks above their 200-day on pullbacks.
There’s an entire generation of traders who like to buy breakouts and some are successful at it. But if you look at the average short-term returns on stocks making 10 day lows above their 200-day moving averages versus 10 day highs, you’ll see significant differences. Stocks making 10 day lows have far outperformed stocks making 10 day highs. And again, this has been seen in testing millions of trades for over a decade’s period of time.
Rule 3: Use the 2-period RSI to find your pullbacks.
We’ve been teaching the 2 period RSI for more than 5 years. In my opinion it’s the best oscillator available to you. And the statistics back this up.
Stocks trading with a 2 period RSI under 2 substantially outperform stocks trading with a 2 period RSI above 98 over the short-term. Instead of “eyeballing” the pullback, let the 2 period RSI identify the pullback for you. It’s a great indicator.
Rule 4: Buy stocks on further intra-day pullbacks.
We ideally want to be buying stocks in uptrends which have pulled back. And then we want to buy them after they’ve pulled back even further intra-day. This one rule alone increases the simulated returns on test results and we especially like it to help filter out the better stocks to buy each day. Look for intra-day pullbacks in the 2%-5% range (or higher) as these are the stocks that have historically been the better selections for short term traders.
Rule 5: Exit on a close above the 5-period moving average.
Everyone likes to tell you when to get in. But we all need to know when to get out.
We have many different exit strategies (all quantified) but to keep this simple, use a close above the 5-day moving average. Once the stock closes above its 5 period moving average its time to get out. This exit is price dynamic, meaning its always adjusting to current price, and it does a nice job of finding the sweet spot of a stocks rally. Once a stock closes above its 5-day moving look to exit (hopefully profitably) and move onto your next trades.
I’ll add a Rule 6 here because of what’s happening in the market this year. And that rule is unless your trading and/or investments are down more than 20% this year, trust that you are likely smarter than many of the “experts” who are giving advice on television. Most are having a very difficult time this year and I’m sure many will eventually bounce back. But in the meantime, until proven otherwise, they are obviously not equipped with the tools necessary to make money in this type of volatile market environment (possibly CNBC could require these people to disclose whether they’re up or down for the year?). And if you’re profitable so far this year, give yourself a pat on the back because you’re in the top 1%-10% of all investors and money managers in the world. And you’ve done it in one of the toughest market environments you’ll ever see.
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In conclusion, when it comes to trading, I’ve always believed that simple is better. Just by drowning out the noise and following the above rules, you’ll put yourself in a better position to be profitable both in up markets and in down markets.
I hope the above guidelines are of help to you.
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Larry Connors is CEO and Founder of TradingMarkets.com and Connors Research.