Rules to Trade by

Chartman recaps some vital points he made at the Online Trading Expo.
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Two Saturdays ago, I had the pleasure of presenting at the

Online Trading Expo

in New York. If you came to see me, I am grateful. Also, I hope I didn't disappoint.

Of course, many of you who were not able to make the show have emailed wanting to know what I talked about. Well, if you're a regular reader, trust me, it's all right there in the archives, buried amid my many columns.

That said, I went back through the presentation, and of the nine or 10 transparencies I showed, only one was of such critical importance that I thought it needed to be brought to your attention. Therefore, I want to spend this column and my upcoming Wednesday column focusing on the four points from that one transparency. For now, forget about the charts. These points are far more important than any chart I could ever show.

No. 1: Your Trade Has No Memory

I cannot tell you how often I get email that goes something like this (we'll call the reader

Joe

): "I bought 1,000 shares of XYZ stock at 100. It's now 50. Should I hang in there?"

Now, what's most frustrating about that question is that it is based almost totally on emotion. It's as if Joe thinks XYZ not only has a memory of where he went long, but some sort of "reversion device" that will bring XYZ back to the 100 level!

Therefore, let's take the emotion out of it and dig a little deeper. Starting with $100,000 and now left with $50,000, Joe is down 50% on his original investment in XYZ. Now, this is most important: The money he lost is not coming back. It is gone. It is vaporized. It is no more.

With that mindset, let's start fresh. Let's assume Joe's goal is to get back the $50,000 he just lost. Straightforward enough, right? It seems to be, but this is where Joe gets bogged down: He can continue to keep his money in XYZ

or

he can put it in any other stock in the universe. It's the latter that Joe always forgets.

Going one step further, XYZ has to rocket back up -- not 50%, but 100% -- to gain back Joe's $50,000. Now, of all the places Joe has to invest, is XYZ the absolute best place to stick his money?

It may well be, but that is unlikely. No, in these situations, there are usually numerous stocks and sectors that are doing well and rocketing upward. It's those stocks Joe should be looking at.

But even if my analysis is wrong, the key point to remember is this: Joe now has $50,000 to invest. He can invest it anywhere in the universe. If he honestly thinks XYZ is the best place for that money, fine. But if he chooses to look elsewhere, XYZ won't remember a thing. Remember, you always have a choice. And often, the best choice is to start fresh.

No. 2: Riding a Winner Isn't Always the Best Way to Trade

Ride your winners and cut your losses short.

How many times have you heard this tired war horse? One of the 10 commandments of trading, right?

Not necessarily. Let me give you an example to illustrate what I'm talking about. Our friend Joe has two choices, both given to him on Jan. 1.

Choice No. 1 is to invest $100,000 in XYZ, which has high odds of rising 300% over the next year. If that occurs, Joe will end the year with $400,000 in his account.

Choice No. 2 is for Joe to use that $100,000 to make two trades a month. And each of those trades has high odds of returning not 300%, but only a measly 7%.

Now, what should Joe do? All else being equal, Joe should make choice No. 2! Why? Because of compounding. That's right, if Joe makes $7,000 on his first trade, he can then roll $107,000 into his second trade, netting $7,500. He then rolls $114,500 into his third trade, etc. -- until the end of the year. The key for Joe is to ensure each of his new trades has the liquidity to absorb bigger lot sizes, but if we make that assumption, Joe ends the year with $507,000.

And I'll give you a few more advantages. I contend it's far easier to find numerous 7% winners than it is to find one 300% winner. That 300% winner has to stay hot for a full year. Why, that's an eternity for a lot of stocks.

On the other hand, Joe is free to move from sector to sector, forever rotating from strong stock to stronger stock. One month B2B, the next month biotech. And if there are no strong sectors, then Joe has the luxury of sitting out that time period.

Now, I'll pre-empt the two most common objections. One, of course, Joe could buy more of his 300% stock as his buying power increased. However, scaling up into a stock isn't usually what most people try to do. Shoot, they're so happy they're up big on XYZ, they often forget they have more buying power!

The other objection is that many folks feel they

can

find those 300% winners year after year. To those readers, I say good luck. (And let me know your '00 selections!)

My point, though, is not to move you from a buy-and-hold style to heavy trading. Shoot, I haven't even discussed tax considerations, so you could throw that at me. Rather, I just want you to not mindlessly go along with the "ride your winners" credo without thinking of your equity as working capital. Remember, the richest auto dealer in town is often the guy turning over those inexpensive Chevys every day, not the guy admiring his reflection in the

Rolls-Royce

(RYCEY)

that's been sitting on the showroom floor for six months.

Food for thought. More on Wednesday.

Gary B. Smith is a freelance writer who trades for his own account from his Maryland home using technical analysis. At time of publication, he held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Smith writes five technical analysis columns for TheStreet.com each week, including Technician's Take, Charted Territory and TSC Technical Forum. While he cannot provide investment advice or recommendations, he welcomes your feedback at

gbsmith@attglobal.net.