10 February, 2009

How Not To Lose Money In The Stock Market

One of the most important rules to remember when investing in the financial markets is to Preserve Your Capital! Not losing money is the first step before you can make any money.

And although I haven't figure out a technique that guarantees 10% yearly gains, I have figured out a pretty good technique for not losing money in major market draw downs. Allow me to show you a chart of one of the ETFs I like to use to trade:

The chart to above shows the daily price for QLD, along with the 50-day exponential moving average (in red) and the 10-day exponential moving average (in blue). At the bottom of the chart, you can also see the daily trading volume.

What's interesting in the QLD chart is that during the past year every major market drop has been preceded by a clear signal: the 10-day EMA crosses the 50-day EMA (heading down, of course). And this, even when the market has faced major volatility and huge daily drops.

You can go back as far as you like, and you'll find that the signal above always hold true. And this is not because I'm so awesome and I've figured out some magic formula - no, it holds true because of the very definition of EMA. The EMA lines just show you the averages of the stock price for the last 50 and 10 days respectively.

Of course this technique isn't perfect: you will lose some money before the 10-day EMA crosses the 50-day EMA; but at least you won't lose more that 50% of your money, like several people have in the past year.

Disclaimer: Don't take financial advice from a guy that writes software for a living (i.e. me). Also, don't take advice that makes a living selling financial advice (i.e. your financial advisor). Those guys don't make money in the markets; they make money making you feel good about losing 50% of your capital.


Mike Murray said...

I had a coworker who plays with this stuff as a second job look at your post. He said your logic is pretty sound.

He noticed that in 2007, you probably wouldn't have made out any better, as the price point for getting back in was often at the same price as when they first crossed before each dip. However, your rule would have saved your bacon 100 times over in 2008.

He said your strategy is a good rule for escaping large drops in the market like we've seen. He also said the safest way to make a reasonable amount of money is to noctice a trend like you did, make a rule out of it, and stick to it with the majority of your investment no matter what. That's how you safely make money (and avoid making stupid mistakes).

Some interesting insights I thought I'd share with you. Kind of a validation of your concept in a way.

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