Strategy #1

So let's suppose that a trader has 6 long positions in a bull market and is risking no more than 2% on each trade. That would be a total risk to the account of 12%. Let's call this Strategy #1.Furthermore, let's assume that the trading method used by this trader is expected to yield an average of 5% (of the trader's account size) profit for profitable trades. If the bull market continues, it is possible that all 6 positions would be profitable, averaging 5% profit each or a gain of 30% to the account. Of course, even though the bull market continues there is no assurance that all 6 positions would be profitable, but let's assume that is the case in this example.

But what happens if just after putting these long positions on, the market abruptly drops like it did in February. In that case, all 6 positions could have been stopped out, easily losing 2% each or a loss of 12% to the account.

Strategy #2

Now using those same market scenarios, this time let's assume that a trader has 4 long positions in a bull market, but also has 2 short positions. Let's call this Strategy #2. Each position is risking no more than 2% on each trade. That would still be a total risk to the account of 12% as it was with Strategy #1. But this time 2 of those 6 positions are shorts, which have a high probability of significantly reducing the risk to the account.

Again, let's assume that the trading method used by this trader is expected to yield an average of 5% profit for each profitable trade. If the bull market continues, it is possible that all 4 long positions would be profitable, averaging 5% profit each or a gain of 20% to the account. But this could be offset somewhat by the short trades that could have been stopped out for a 2% loss on each trade or a loss of 4% to the account. The net effect being a gain of 16% to the account (+20% on the longs, ?4% on the shorts)

Not as good as the 30% gain with Strategy #1, but let's see what could happen if just after putting these positions on (both the longs and the shorts), the market abruptly drops. In that case, all 4 long positions could have been stopped out, easily losing 2% each or a loss of 8% to the account. Now for the good news - with the 2 short trades as a hedge, both of those trades could have averaged 5% profit or a gain of 10% to the account. The net effect being a gain of 2% to the account (-8% on the longs, +10% on the shorts).

So, with Strategy #2, while the theoretical profit potential is not as high if the bull market continues, the theoretical outcome if the market drops abruptly is still a gain of 2%, while in the first example, with all 6 positions being long the account could have lost 12%.

The table on the previous page summarizes these examples for the two market scenarios.

Since the market is unforecastable, in order to protect your account from excessive losses, I believe you must employ some type of hedging strategy such as I have outlined above as Strategy #2. By definition, a hedging strategy has a cost to it. In this case in the form of lesser gains should the bull market continue. But I believe that such a hedge is well worth it if it can minimize losses or even produce a net profit when the market goes against me.

And don't forget, the market does not have to fall abruptly for Strategy #2 to be effective. Even in a protracted bull market, there will often times be frequent corrections downward that can easily produce similar outcomes to the scenarios above.Strategy #2 can, of course, also be applied in a bear market by putting on 4 short positions and 2 long positions. I would also like to point out, for option-savvy traders, that the creative use of options can also be used as an effective hedging strategy. But a word of caution: do not trade options unless you have had the proper education.

A Few Caveats

In the preceding scenarios, the trade outcomes could clearly be different than those assumed. Some of the profitable longs and shorts could have been more or less profitable or even losers. And some of the losing longs and shorts could have been profitable or even lost more, but I think you get the point of how a simple hedging program can be used to dramatically reduce risk to the trading account. Important! When using a hedging strategy like Strategy #2, always be sure to only consider trades that your trading method tells you to consider. In other words, in a bull market, for example, only put shorts on as a hedge that your trading method tells you are potentially good short opportunities.

The Trend Finder

Now, many have asked, ?How do I determine whether or not it is a bull or bear market, anyway?? Or, ?I can't really hedge the market if I don't know what the trend is.? These are very important questions, because most of the advice we get on these questions from the analysts, the so-called experts, the media, you name it, is just not very helpful. And to make matters worse, these experts often disagree on whether it's a bull or a bear. Now imagine if there was an objective way to determine the trend of the overall market that anyone can follow. Well, thankfully there is.

Here is a simple method that I have developed to determine overall market trend at all times. While no method will identify tops and bottoms with any accuracy (and don't believe anyone who tells you differently), my method will keep you on the right side of the market most of the time. This is the method that I use in determining a bull or bear market with my hedging strategy I described earlier.

The Formula

When the 50 and 200 day simple moving averages for the S&P 500 are both up, I consider the market to be in a strong bull run and recommend trading twice as many long positions as short positions.

If both are down, I consider the market to be in a strong bear run and I recommend trading twice as many short positions as long positions.

If one is up and the other down, I consider the market to be a mixed, choppy affair. If a mixed choppy market, I recommend cutting back on position size and number of positions and recommend trading an equal number of long and short positions.

I have found this simple approach to be far superior to any guru's or media forecast on market direction.

Now, in case you think this method is too simple, I would urge you to plot these moving averages on a historical chart of the S&P 500 and see for yourself how useful this method is in identifying bull and bear markets.

Take a look at the chart above and on the next page for a few examples of this.

Remember, simple, but no simpler.

So What Now?

The bottom line is that controlling your emotions and trading with discipline are essential to becoming a successful trader. And I believe the number one nemesis for anyone in this regard is stress. When under stress, you become emotional, are prone to making mistakes and will tend to become undisciplined. So why trade assuming that the market will always go your way, throwing caution to the wind, and setting yourself up for unwanted stress? With the proper hedging strategy and willingness to absorb the relatively small cost of hedging, you can largely avoid stress and stay focused, emotionally in control and disciplined because you have already taken steps to deal with a market move against you long before it happens. And those market moves will happen. Again and again.

Trading Education & Market Direction

So here's the bottom line?

Real traders don't get spooked when the market drops out like it did in February. That's because they have the potential to make money no matter which way the market moves. When the market is trending up, their method gets them into long positions. And when the market heads south, their method gets them in short positions.

And incidentally, in a bear market prices tend to drop more quickly than prices go up in a bull market. This is great news when your trading method identifies short-trading opportunities.

So as you can probably tell, all this ?noise? in the news about the market falling out doesn't bother me.

And it shouldn't bother you, either, if you have a good trading method.

On the other hand, if you are confused, anxious, and don't know what your next move should be in the market, then I believe you need to get properly educated immediately and get your hands on a good trading method.

In fact, I would argue that now is the perfect time to study a new trading method, practice paper trading it, and learn it cold. Then, when the next big market trend hits, you'll be poised to potentially pull profits out of that trend.

However, if you wait for the next big trend to rear its head and you're still making trading decisions in an uneducated, ?willy-nilly? fashion, you'll be scrambling for cover when your positions go against you.

My kids call me ?old school? because I believe in studying, taking your time, and putting ?sweat equity? and ?elbow grease? into any endeavor that you pursue in life.

Trading is no different, and there's no better time to start learning how to trade properly than the present.

So, buckle down, sharpen your pencil, and get up close and personal with a good trading method today, not tomorrow.

One final comment on trading education in general, and you may have heard this before.

When you want to learn anything new, you're going to pay for it. Period. You're going to pay for it with time, with money, or both.

And what I learned with regard to trading is that you can either pay the markets, or you can pay a mentor. Particularly with trading, I believe it's vastly more economical to pay a mentor.

Good trading,

Bill Poulos

p.s. If you'd like to download this entire article, just go to http://www.pruntracker.com/Nav2007