Among the many back-and-forths regarding the April Fool's

column and

follow-up, there was one very important question raised by reader

Bob Mercer




take you out? You trade with stop-loss settings, counter balance of shorts to longs, and as near as I can figure, a position size that is a safe portion of your trading capital. It is unlikely that a single day or even a week would take you out.

Now, Bob has asked a very important question, and as a discussion point, I thought I'd tackle that today. We'll use my methodology and money management parameters as an example, but of course, the real emphasis is to get you to think about how well your own style would hold up under a variety of situations.

First the setup. Let's assume my trading account has $1 million in equity. Let's also assume my average lot size is 5% of equity, or $50,000. Using full margin, this allows me to have about 40 positions open at the same time. That, by the way, is about the most I ever do have open, and I've found that's only the case in heavily trending markets, going either straight up or straight down -- much more the former, by the way. (On the short side, I think the maximum I've had open at any one time is about 20 positions.)

Finally, let's assume my average profit and loss on each trade is about 5%, but I have about a 70% win rate on both sides.

(The equity balances, by the way, are fictitious. The money management and win rates, are fairly close, though. Perhaps a bit conservative, but who knows by year's end!)

Finally, let's assume I only play breakouts from congestion, on both the long and short side. I do take other types of trades, but they make up only a minor part of my transactions.

Given this setup, let's look at the various types of markets and see how I fare:

Trending bull market (Think October '99 to January '00)

It's no surprise to many, but this is where I really shine. In fact, if I could figure out a way to


trade these types of markets, I'd easily do 100% a year, year in, year out. But, whatever, there's no risk of me going down under this situation.

Trending bear market (Think April '98 to October '98)

This wasn't specifically a bear market, but probably as close as we've come in the past few years. Again, this was nirvana for me, as I had nothing but shorts show up day after day.

Choppy, up and down markets (Think right now!)

When the market acts like it has the past few days, frankly, I get chopped to pieces. The only good news is that these choppy periods never last that long, and in addition, my long and short candidates eventually dry up. There are really very few breakouts to play, so by definition, I have very little equity at work. A good example was the morning of April 5, as I indicated in my column that day. I had the

Procter & Gamble

(PG) - Get Report

long and about four shorts. And that was it: roughly 20% of my equity at work, with my exposure being about 1% of my equity, if every trade closed for a loss. So, in order for me to go bust during a market like this, the choppiness would have to extend for months, I'd guess, and during that time, my trading would have to be really dreadful.

However, choppiness like we're currently experiencing rarely lasts very long. (Dreadful trading, however, is always a possibility!)

OK, those are the three main types of markets, and it looks like I can survive those. Let me give you one example, though, where I could get nuked.

As I mentioned earlier, I am at full margin in heavily trending bull markets. So, I suppose if I had 40 open long positions, and the market gapped open one morning, down 50%, then yeah, I'd be wiped out.

But, that's not really how markets work. If you go back and look at any catastrophes we've had over the years -- October 1929, October 1987, a few days ago -- you'll see the big selloff always comes after a series of down days. The huge washout is never a complete surprise, but normally a crescendo to an existing downtrend.

And, in that scenario, I am almost certainly out of most of my longs, and probably have at least a handful of shorts working. As an example, this past Tuesday's action cut into my portfolio about 1% because I had a few open longs, but also a few shorts working.

No, about the only wipeout scenario I can imagine is a market that


gap down 50% from an upsloping trendline. Now, under what scenario could that occur? I guess if scientists discovered a meteor actually


going to hit Earth. Or, if China had nukes on the way, due to arrive at noon.

Yeah, those scenarios would pretty much wipe out both me and the market. Of course, if that was the case, I'd probably have more pressing things to worry about than my brokerage account.

So, I certainly haven't witnessed every type of market, but on the surface, I could make my way through most of what's gone on so far. That's not to say I'd thrive in every situation, but I'm relatively certain I could avoid catastrophe.

Now, imbedded in all this analysis are a few things you need to think about for your own trading:

No. 1:

Do you have a strategy to use margin appropriately? Some of you were under the impression I opposed the use of margin. That couldn't be further from the truth, as you can see from my examples. No, what I'm opposed to is the use of margin

without a plan


No. 2:

Do you have a plan to attack the market if it goes up


down? Now, I'm not saying everyone has to have a method to go long and short. However, you at least have to have a method to not go long in a down market!

No. 3:

Is your methodology solid enough to make money in calm times? At the root of all this analysis is the fact that while I might not be the best trader in the world, I can at least make money most of the time. However, if you just stink as a trader, it won't matter what the market looks like: You'll probably lose it all eventually.

So, your method is really where it all starts. Work on that first, then customize it to work in a variety of situations. Everyone wants to be a great trader, dreaming of compounding their gains 500% a year, year after year. The ones who last, though, generally aren't those folks. No, the ones who last are the ones who know how to avert disaster and live to trade another day. They might not be the flashiest, but in the end, they're generally the richest.

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 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