The Strategy

My strategy is based upon the principles discussed in my previous blog, “Market Analysis,” but the execution of it has been developed and tested over time. There is no wrong or right way to trade the market. There are only techniques. This is the one that has worked for me.

I do not have to determine the exact market top or bottom, but I’ve gotten pretty close anyway. On Wednesday, November 19, 2008, the market experienced a brutal sell off after roughly 2-3 months of decline. At the end of that day I wrote down the values of major market indicators. I thought that was the bottom. I was wrong.

From late November until early March, the market basically traded sideways. I was buying the entire time. When it launched a new rally in March, I was already almost 100% invested. I began to buy on margin.

I mention this because it illustrates a real world example that proves you don’t have to pick the bottom. You just need to be ready when the market begins a new rally. My strategy achieves this objective.

So what did I buy? I did make one mistake and that was to trust my own ability to time the bottom, within a specific time frame. I believed that the new rally would begin within 3 months. Again I was incorrect. Instead of launching a new rally in early February, it did not occur until early March. By purchasing options that expired too early, I missed out on some potential gains.

That mistake aside, I made a lot of positive moves. Focusing on Asia, I purchased Chinese ADRs that were poised to move higher. This strategy worked to my advantage. Purchases of commodity ETFs did not prove to be as profitable, but served a diversification purpose and allowed for inflation protection.

Which brings me to my final and most important topic: protection. Gains from stock and option purchases have proven the merits of this investment strategy, but only because the market has continued to rally. But what if the market rally had failed or some catastrophic event had occurred? How does one protect against the unknown?

The answer is two-fold: put options and stop loss orders. In order for this strategy to work, an investor has to protect against catastrophic loss. No gains can offset a drastic and immediate loss caused by an unpredictable event. An asset could plummet and it may not even be provoked by such an event. My personal preference is to use put options for large positions with long term potential. Stop loss orders are best used for short term trades. Sometimes a combination of the two is required. It depends on the asset.

The most important thing to remember when investing is that avoiding loss is more important than creating gains. Think about it—if you outperform the market by protecting against loss during the down periods and underperform the market during rallies, you will still come out ahead. This strategy not only seeks to outperform in bull markets, but will also lead to substantial gains in bear markets. If you can get even close to timing market bottoms and market tops, you can benefit from either scenario.

As I write in early August 2009, the market is still in rally mode and has yet to show signs of breaking down. I fully anticipate that the rally will continue for 1 – 2 more months. By October, the rally should end. Even if I am incorrect, I will still profit. If the rally ends early, my put options will protect against loss. If it continues to rally beyond October, I may miss out on the end of the rally. I would rather sell on the way up than the way down. I would rather buy before the rally begins than after. I would rather be early than late in all situations. That is my personal preference and the strategy that I believe will work best in the long run.

In addition to protecting against loss, the best strategies also seek to profit from bear markets. Taking short positions, buying short ETFs, and purchasing put options are all strategies worth employing in preparation for a bear market. Protection should be put in place in the opposite manner by purchasing puts, calls and continuing to use stop loss orders. An additional technique of purchasing foreign currencies could prove to be an added source of protection. The Japanese Yen and Swiss Franc are good examples of hard currencies worth owning in bear markets. Gold is almost always a good investment and useful protection against rising inflation rates.