More Questions, More Answers

Yesterday, I concluded with a discussion of what I call "The Platinum Rule" of trading. Go back to that rule regularly and study it. You'll need to know it inside and out in order to be a successful trader. For now, though, more Q&A.

Q: You mentioned that a trader's goal should be to generate "the maximum amount of profits for as much risk as you can stand." How do you define risk?

A: First, know that there are many trading methods that can generate extraordinary profits. But every high-profit method I've seen also comes with outsize risk. In order to make a lot, you have to extend a lot. That's straightforward. But, that risk -- which I define as drawdown (the maximum percentage pullback from peak return to trough, before the previous peak is exceeded), can ruin a trader.

As an example, let's say you have a method that returns 100% per year. Well, in order to achieve that, a drawdown of maybe 50% may occur every few months. On paper, that seems manageable. After all, you're getting a 100% per year return.

But let me tell you. When you start with $100,000, then build it to $200,000, only to see your equity drop all the way back to $100,000 again, well you don't think you'll recover. Ever. No, you think that $100,000 is going straight to zero! You then panic and invariably abandon your methodology just when your equity curve is about to rebound.

So, you not only experience the devastation of living through a big drawdown, but also the deleterious effect of missing the big move back up.

It's for that reason that you absolutely have to concentrate on risk, as I've defined it, when thinking about which methodology to pursue.

Q: OK, I understand "The Platinum Rule" and drawdown. But I'm still confused as to how you find the right mix of variables. It seems impossible to do this by hand.

A: With all the variables you need to solve, you need computing power to do a thorough job. There are a number of back-testing software programs, so I recommend you look at Wealth-Lab.com, Traids.com, or AmiBroker. It might take several iterations of testing, refinining, and then retesting, but it is well worth the trouble. Frankly, any other approach is guessing.

When I do my testing, I try to load in all the longs and shorts I've picked in the past. Then I put in some reasonable targets and stops, including a time stop if appropriate. I then let the back-tester crank and establish a baseline return. From there, it's just a matter of tinkering with the variables until your return vs. drawdown starts to improve. Variables to examine? Stops and targets, of course, but also:

Lot size;

Time of entry (i.e. at the close or at the open);

Time of exit (close or open);

Type of stop (hard stop, mental stop, trailing stop, etc.);

Type of target (hard or mental);

The order you pick your trades (i.e., do longs have precedence over shorts if your capital is limited?) Amount of equity to use (up to 200%).

Yeah, it's a lot to think about. And it usually takes years to get a handle on things. But again, the effort is worthwhile.

Tomorrow I'll discuss the few simple tools I use in my trading.

Today, the Dow Jones Industrial Average, Chicago Mercantile Exchange Holdings(CME Quote), 3M(MMM Quote), Axonyx(AXYX Quote), Lexar Media(LEXR Quote), and Charter Communications(CHTR 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 Philadelphia, where I'll admit I don't understand rabid support of professional sports teams. Sure, many years ago, a professional player had a reciprocal relationship with his city because he played there for more than a few years. Mike Schmidt may have had zero in common with Gary Smith, but at least he lived long enough in the area to be a "Philly Guy." But now it seems like you're rooting for your mercenaries to beat their mercenaries! Tough to get interested in that.

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.