How to Avoid Big Losses and Execute Winning Trades Without Knowing What the Market Will Do

I know this headline just sounds too good to be true and nobody could blame you if you stopped reading right here.

Consider this though: It is said that a penny saved is a penny earned. It sounds cliche but it's accurate. If your stock portfolio is down by $1,000, you have to earn an extra $1,000 to bring your net worth back to even. So a penny saved really is a penny earned.

Now ask yourself; How much money did I lose since the May highs or the beginning of the year? To make up for the loss, you'll have to work extra hours. But what if you didn't lose any money? You would have preserved your purchasing power and be able to buy at lower prices (if you so chose).

In other words, knowing when to sell a position is equally - if not more - important than knowing when to buy. Buying low and selling high (or the opposite if you are shorting the market) require serious insight about the market.

Here is one simple strategy that protects your profits and helps you identify winning trades without having a clue of what the market - whether Dow Jones (DJI: ^DJI), S&P (SNP: ^GSPC), Nasdaq (Nasdaq: ^IXIC) or Russell 2000 (Chicago Options: ^RUT) - is going to do next.

Below you will find some actual trade recommendations. The number in front of the trade recommendation in the article corresponds with the number in the chart. Red numbers were sell signals, green numbers were buy signals.

Blind as a Bat but On Target

Bats have poor vision but they always find their target simply because they work effectively with what they've got. Nobody has 'stock market radar vision,' so we too have to work with what we've got. We need to identify an edge and exploit it.

Every person may have a different 'edge.' My edge is knowing the S&Ps hot buttons - levels that tend to force the S&P to change trends or confirm a trend (the red and yellow lines drawn in the chart show some hot buttons).

Imagine a car driving on a long road with a few traffic lights. If the car is going to stop, accelerate, or make a U-turn anywhere on the road, it will most likely be at a traffic light. If the S&P is going to reverse, it will likely be at support/resistance.

I spend much of my work hours identifying support/resistance levels. Trend lines, Fibonacci, pivots, sentiment, prior highs/lows, etc. are important tools to identify such hot buttons.

The Big One

Like a home builder that starts out with the foundation and the frame, I start out by 'building' a rough, big picture outline. If you've been a subscriber or even if you've just been reading my articles, you know that I've been harping about a major market top.

The chart below was published in the April 3 ETF Profit Strategy update and explains why a major market top was expected.

The ideal target range for this top was 1,369 - 1,382. This resistance cluster was made up of Fibonacci resistances and the upper trend line of a multi-decade bearish M top formation.

1) (See chart for corresponding number) The May 1 ETF Profit Strategy update confirmed that: 'A move to 1,369 would be close enough to consider the right side of the giant M-pattern as completed.' The very next day the S&P spiked briefly to 1,370.58 before reversing.

The Rollercoaster

The May 2 high was followed by a three month rollercoaster finished off by a meltdown. There was a temporary bottom at S&P 1,258 on June 16.

2) The June 15 ETF Profit Strategy update stated:

'The 200-day SMA at 1,257 is sandwiched between the 1,255 Fibonacci projection level dating back to 2002 and this week's s1 at 1,259. Wednesday's low was at 1,261.9. If this low is not enough, there is a strong cluster of support at 1,259 - 1,245. A drop into the 1,259 - 1,245 range would prompt us to close out short positions and leg into long positions.'

The Curveball

3) Unfortunately no strategy is perfect. The July 4 ETF Profit Strategy update suggested to short the S&P at 1,340 with a stop-loss at 1,348. The July 6 TF added: 'If the S&P does spike above and falls back below 1,347 we will re-enter the short trade. If the S&P stays above 1,347 we'll watch and wait for a day or so and may go long. However, if the S&P moves higher the VIX will be around 15. Owning stocks with the VIX that low is a risky proposition.'

In a not-so-unusual effort to clear out stop-losses, the S&P closed above 1,348 for one day before reversing. In seesaw situations like that, investors need to be flexible and sometimes close and re-enter positions.

4) We took one more stab at going long at S&P 1,300 and got stopped out at 1,330. To emphasize, all long positions were closed at 1,330 on July 27. From there on, the stock market (NYSEArca: VTI) went down hill.

5) The 25 ETF Profit Strategy update already forewarned that: 'due to the potential debt-related down side, aggressive investors may go short if the S&P drops below 1,325.'

Forget Your Personal Preference

Even if your personal outlook differs from technicals, it's best to stick with technicals. I learned this when I wrote in the July 27 update: 'For some reason I still can't get myself to abandon the prospect of higher prices. Nevertheless, support was broken and the S&P saw a failed daily percentR low-risk entry today, so we'll go with the (bearish) flow.'

6) Just a day later, the possibility of panic selling became real: July 28 update: 'A break below the 200-day SMA and the trend line may trigger panic selling. One way to avoid missing out on a potentially big opportunity is to use the 200-day SMA at 1,284 as delineation between bullish and bearish bets - buy as long as the 200-day SMA serves as support, sell if it becomes resistance. If the S&P seesaws, repeat the process.'

New Lows or Not

The big question is whether the decline is over and done with or if there will be new lows. Based on various patterns, such as the 2007 market top mirror image, VIX (Chicago Options: ^VIX) topping pattern, market bottom patterns and sentiment, the low doesn't seem to been in yet.

But, I trust technicals more than my personal bias. 1,173 was major support. Tuesday's updated recommended to go short when the S&P violates 1,173. As long as the S&P stays below, we will be looking for lower prices. Worst case scenario we're proven wrong and have to close out the positions without net gain at 1,173. Ideally we'll get to close out short positions once the S&P reaches our downside target.

This approach to investing isn't foolproof. But allowing the market to establish support resistance levels along withincremental trading ranges makes it possible to maximize the gains and minimize any losses.

I share all my research on the various support/resistance levels, along with the target for this rally and the next low via the ETF Profit Strategy Newsletter . Today's Newsletter also provides an outlook for the remainder of 2011.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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