Staying in the Saddle

Author:
Publish date:

I was going to respond to a reader's request today and pen a column on "getting back in the saddle" after you've been rocked for a few losses. But, after digesting all this

Long Term Capital

news, I thought I might do a prequel on how to not fall out of the saddle to begin with.

Of course, I don't pretend to know how my Greenwich neighbors got into this mess, nor do I pretend to be any smarter than they are. Instead, I know how dumb I've been in the past, so if we can't learn from Meriwether and friends, at least we can learn from GBS's "Short Term" Capital Fund.

Therefore, think of this column as a set of checkpoints and safety precautions you should think about at all times. Yes, if you've read anything about trading, you've seen these points made before. Heck, I even had to fall back on some of the standard cliches. But sometimes these cliches stick around because they work.

Now nothing is foolproof, of course. Nothing. The market could open down 5,000 and if you were long, you'd be wiped out. However, short of nuclear holocaust, the stuff below should help avert disaster.

Rule #1: Know What You're Doing

I am heartened whenever I get an email from someone who said they paper-traded my methods, or any methods, before they used real money. Bravo! Unfortunately, that's not the norm. No, the norm is to get an account on

E*Trade

(EGRP)

, log on, and begin firing away with live ammo.

I mean shoot, in a great big bull market, it's just like the Grand Prix raceway at Disney World: You can only go forward, and no matter how inept you are, you just can't go off the track!

So, you get a bit overconfident, and think you're blessed with some God-given trading prowess. You brag to your friends about how smart you were to have bought and sold

Dell

(DELL) - Get Report

for a very handsome profit. They are amazed and impressed. You start to believe your own hype.

And then the market goes down. Relentlessly. And you lose your confidence. And you try to get back to your winning ways, only to discover you had no winning ways. You only had a bull market.

Rule #2: Know Your Downside

A few columns ago I talked about money management. And one of the techniques I mentioned was using a compound order. That is putting both your stop and your limit order in at the same time. Now the beauty of that is the flexibility, but the key feature is knowing my downside risk upfront.

In other words, once my stop loss order is in, I know exactly how much I can lose. Whether your stop is based on statistics, as mine is, or on volatility, or on technical analysis, you should put it somewhere. And, if at all possible, it should be a firm order.

Why a firm order? It is way too tempting, and I mean

way

too tempting, to move your stop down in order to give your stocks "breathing room" when the market is volatile. Bad move. I've done that over and over and over. Why?

Because I'm an idiot!

No, take the emotion out of it. Put your stop in place and expect it might get hit. And right after it gets hit, the stock will bounce right back and go on for some nice gains. So be it. Edwards and Magee phrased it perfectly in

Technical Analysis of Stock Trends

:

You had your reasons for setting the stop. The stock did not act the way it should have. The situation is not working out according to Hoyle, certainly not the way you hoped it would. Better to be out of it, even at a loss, rather than face a period of uncertainty and worry. If the stock has started to act badly, you cannot tell how much worse it is going to behave. If you fail to set a stop, you may go on day after day hoping for a rally that never comes, while your stock sinks lower and lower, and eventually you may find that what started to be a small reaction and an annoying but trivial loss has turned out to be a ruinous catastrophe.

Rule #3: Plan to Get Hit, Not Wiped Out

I am very long right now, with 10 open positions. And as I write this on Friday morning, the market opened up nasty and looks fairly sour. So while I'm not pleased to be getting hammered, I'm secure in one thing: If I get stopped out of every single position, you know how much my portfolio dips? Less than 5%. That's right, I could swing a bigger load, so to speak, but I don't. No, on every single trade, I have less than 0.5% of my portfolio at risk.

Why so little? Am I scared? Hell, yes. On every single day, on every single trade, I'm scared to death. That's why I trade small. I don't like to get pounded, but if I do, I can take it. And live to trade another day.

Rule #4: Be a Negative Nellie

When I was still with

IBM

(IBM) - Get Report

, but considering leaving to trade and write full-time, I broached the subject with my wife. I wowed her with my gains and trading prowess, and she listened intently. And I'll never forget her first question? "What will you do if the market goes down?"

My response: "Uh . . . ummm . . . duh." Yeah, that's right, eloquent as ever. I had essentially started trading in 1987 and had always known one direction: up. I had no plan for "down." Nothing. Oh, I knew about shorting, and puts, but who ever needed that stuff. So essentially, I had no "gee, the market has been going down for six months, now how do I make a buck?" kind of strategy. I was Mr. Pollyanna, and that was fine. But somewhere in there I needed to at least think about Negative Nellie coming to the party. And hopefully benefiting from her presence.

Rule #5: Have a "Lunch Bucket" Mentality

One summer between college semesters, I worked at a cardboard box factory. Real glamorous job: heavy-duty dust; no air-conditioning; and paper cuts by the dozen. Every day it was a battle between bleeding to death, and dying of monotony.

First week in, and I didn't think I could handle it. So I asked one of my Teamster brethren (right, I was a proud Union Man!), how he handled it. His answer: "I grab my lunch bucket, I come to work, I do my job, and then I go home." Oh. OK. Kind of a Zen thing, I guess.

But, it worked. I had a job, I showed up, I did it, and then I went home. Now, I love trading a lot more than gluing cardboard together, but my mentality is the same: I have a job, I show up, I get it done, and then I go home. In other words, I don't get distracted by

CNBC

. I try desperately not to be impacted by the futures. I don't worry about Chief

Greenspan

. And I could care less what "Heard on the Street" has to say.

And that's the best advice I can give anyone on staying in the saddle. Find a method that works in all types of markets. And then stick to it. There's no need to get fancy, or take undue risks, or sweat bullets on every trade.

Just keep it simple, show up, and do your job. You really don't want your trading to be glamorous. You want it to be boring.

Gary B. Smith is a freelance writer who trades for his own account from his Connecticut home using technical analysis. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. This column, Technician's Take, appears every Monday. Smith also writes Charted Territory, which appears every Wednesday, and TSC Technical Forum, which runs Saturdays.