Market prices move in trends and traders can make, and more importantly, keep large profits if they are on the right side of the trend. Keeping profits requires investors to move out of markets that are falling and switch to cash or take short positions that can benefit from declines. The importance of avoiding large losses is obvious after the bear market that began in 2008 when many investors lost 50% or more of their account value.

A simple trading strategy of following the 10-month moving average (MA) would have helped traders avoid almost all of the losses in that bear market. When using an MA trading strategy, traders buy when the price closes above the MA and sell when the price moves below the MA. On SPDR S&P 500 (NYSE: SPY), this strategy delivered a sell signal less than 8% below the market top in 2007.

The long-term success of the 10-month MA has been well documented in Mebane Faber’s The Ivy Portfolio and several other papers by the technician. Over the long term, being in the stock market or bonds, or nearly any other investment, only when the price is above the 10-month MA would have beaten the results achieved by a buy-and-hold investor. This is because prices will be above a MA when they are trending higher and below the MA in downtrends. When looking at results for periods of 30 years or more, trend following indicators will almost always be profitable.#-ad_banner-#

In the chart of SPY shown above, one of the problems with trend following strategies can also be seen. After the bear market, the buy signal was given at the end of June 2009 and traders would have bought SPY nearly four months after the bottom was reached and after prices had already moved up by 37%. Delayed entry signals like this can cause the system to lag buy-and-hold returns in bull markets.

Because of late entries at the bottom and whipsaw trades that can occur as the trend is changing, this strategy can underperform buy-and-hold investments over a period of years. In fact, outperformance and underperformance seem to alternate over different time frames.

From the beginning of 2000 through the end of 2012, traders using the 10-month MA to time long trades in SPY would have more than doubled their money while a buy-and-hold investor would have seen their account grow by only 51%. But since 2009, traders relying on the MA strategy would have seen a gain of about 29%, less than half the 64% gain of the buy-and-hold investor.

One of the biggest benefits of the 10-month MA might be the way that it reduces risk. Since 2000, a buy-and-hold investor in SPY would have lost as much as 51% of their account balance. The steepest loss for a trader following all of the MA sell signals would have been about two-thirds less, or 16.6%.

Similar results are seen when testing PowerShares QQQ (Nasdaq: QQQ). This ETF ended the year 28% below its January 2000 price and was more than 81% from its all-time high. Traders following a simple 10-month MA have a gain of about 45% and never showed a loss of more than 26%. But since 2009, the buy-and-hold investor has beaten the trader.

At the end of 2012, the 10-month MA was warning traders that the next year could bring lower prices in QQQ. That ETF ended the year about 1% below its 10-month MA. SPY was above its MA but momentum had turned negative and the stochastics indicator was on a sell signal.

One bright spot in the market is small caps. iShares Russell 2000 Index (NYSE: IWM) is leading the market into the New Year.

The 10-month MA is an indicator that can be used to define the trend in the price of any market. For now, it is warning traders to avoid QQQ, which is also on a stochastics sell signal. Other ETFs are still in uptrends but are showing signs that momentum is overbought and slowing.

Traders looking at committing new funds to the stock market should limit their buys to small caps, which are in an uptrend with bullish momentum.

Action to take –> Avoid new investments in QQQ and large caps. Buy IWM and small-cap stocks as long as the chart remains bullish.

This article originally appeared on ProfitableTrading.com:
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