The Chartman's Key for Traders

If you remember one thing about trading, remember that your equity is your inventory. And therefore your goal is to turn that inventory so that each year it generates the maximum amount of profits for as much risk as you can stand. That sounds complicated, but I've defined that goal with this equation:
((Win rate x win percentage) - (Loss rate x loss percentage)) x (equity per trade) x (trades/year) = profit/year

Now, anyone who has taken beginning algebra can see there is an infinite number of variables one can substitute into this equation that return a positive number. Your goal is to test all reasonable variables, knowing that each variable impacts the other variables, until you come up with the highest profit per year you can.

Let's use the following example. Say my win rate on trades is 70%, making my loss rate 30%. Every time I win, my return is 4% and every time I lose my loss is 5%. I put $10,000 on each trade and make 100 trades a year. Therefore, my profit per year = $13,000.
(70% x 4%) - (30% x 5%) x $10,000 x 100) Now most traders would say that's good, but if I just hold out for a higher win percentage, I can make more money. But, is that true?

Let's say you take profits at 6% instead of 4%. In that case, your win rate invariably drops, as fewer trades reach that level vs. the 4% level. And of course, if your win rate drops, your loss rate must go up. Furthermore, and this is what most people miss, in order to nab that 6%, you have to hold each trade open a bit longer. Holding each trade open longer prevents you from making those 100 trades per year. Instead, you might be restricted to making only 70 trades per year. However, if you're smart, you'll see that eventually and start to put more money on each trade (in this case maybe $12,000). Now, let's see how this new "higher profit percentage" trading methodology looks, assuming the win rate drops to 50%.
(50% x 6%) - (50% x 4%) x ($12K) x 70 = $8,400

You can see that just raising the profit percentage did not increase overall profits but rather decreased them. However, the bigger lesson is the interdependence of variables, and how changing one has a ripple effect on the others. Trust me, if you understand that, you'll have captured a concept that almost no trader I encounter ever thoroughly thinks through.

Time for Questions

On Friday, I talked about my overall trading philosophy of "shorting fear, and going long greed." As straightforward as that is, it does beg a lot of questions, so for this latest installment in this series on my trading style, I'll use a Q & A approach:

Does your approach allow you to do well in all types of markets?

For the most part, yes, and the reason is simple. By simply trading the picks I see, I am usually in sync with the market. So when the market is trending up, you will see a lot of upside breakouts. Therefore, I will primarily be playing the long side. Conversely, when the market is trending down, I will see a lot of short opportunities.

When the market does a sudden reversal, are you ever caught holding a lot of longs?

Usually the market reverses when it's overbought. In that case, I've already taken profits on most of my longs and have gotten into very few new longs. That's due to the fact that I play breakouts, but breakouts that aren't too v-ish. So, if the market shoots straight up, I am continually cutting down on my long exposure. As an example, right before the recent turn in the market, I had no new long picks in the prior week.

Does your analysis of any of the indices -- The Dow Jones Industrial Average, Nasdaq, etc. -- impact your trading?

No. I simply trade the picks I see, regardless of how bullish or bearish I am on the index chart. In fact, I often find my picks are good indicators of where the market is going rather then where it's been. (I am testing this theory with a chart called "The Ginsberg" in my newsletter.)

How do you establish your stops and targets for each trade?

This is one area where most traders screw up, or at least don't think through as much as they should. As for fundamentalists, they never think about any of this, and that's to their detriment.

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I'll answer more questions tomorrow, but now let's get to charts on the Nasdaq, Headwaters (HDWR Quote), Owens-Illinois (OI Quote), Durban Roodeport(DROOY Quote) and Identix (IDNX Quote).

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Charts produced by TC2000, which is a registered trademark of Worden Brothers Inc.

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And that is the final word from Friendly Fenway, where even I'm beginning to believe in the Curse of the Bambino. No team should have to live through what the Sox go through seemingly every year. And don't forget - now is a great time to learn how to make bigger, faster profits with technical analysis and charting. Get a free trial of my newsletter, The Chartman's Top Stocks and follow along with me.