Trading this market is NOT rocket science

Dave Landry is principal of Sentive Trading, a money management firm, and a principal of Harvest Capital Management. Mr. Landry is the author of two top selling books, Dave Landry's 10 Best Swing Trader Patterns And Strategies and Dave Landry On Swing Trading. If you would like a free trial to Dave's Nightly Swing Trading Alerts Report click here or call 888-484-8220 ext. 1.

Surviving a Big Loss

I'm going to do something you've probably never seen any financial columnist do: talk about a LOSING trade. Shocking, huh? Well, here it goes: Legg Mason (LM | Quote | Chart | News | PowerRating), mentioned recently in my trading service, imploded earlier this week. Following my general rules, let's walk through this.

First, the rules: I recommend risking only 1-2% of your portfolio per position. This way, you can be wrong quite a few times and still be in the game. I also recommend taking half of your profits when the stock reaches a level that is equal to or greater than your initial risk in points. For instance, if you are risking 2 points, then you take partial profits (half) when you're ahead by 2 points. Further, I also recommend applying some discretion when faced with a large loss---implement a damage control plan. These rules are available in my primer, articles, and webcasts. Email me if you need links/copies.

Now, let's get to the trade. LM was recommended on 09/19/06. The suggested entry was 99.55 with an initial protective stop at 94.55 (5 points). This gave us an initial profit target of 104.55.

This is what the chart looked like on that date:

Now, to keep the math easy, let's work with round numbers. Assuming a 100k account, a full 2% position would mean that you would risk $2000 on the trade if stopped out--baring overnight gaps. Therefore, based on a 5 point protective stop, 400 shares would be the position size ($2000/5=400).

After a slow start, the stock eventually rallies to hit the initial profit target. At this point, half of the position--200 shares--are sold at a profit of 5 points for a net gain (less commissions/slippage) of $1,000. So far, so good!

Well, in this business, it's never good for too long. On the following day, the stock implodes. In a situation like this, I recommend implimenting a damage control strategy (see "Opening Gaps: Trade'em, Fade 'em, or Ignore 'em", "How to Add a Layer of Discretion to Your Swing Trades", and my prior webcasts). Essentially, you pull your protective stop and wait to see if the stock quickly reverses. If it doesn't, you have to be willing to exit, no questions asked. Well, in this case, it did not reverse. Therefore, assuming you lost another 2 points plus from the open while applying a damage control strategy, this would mean that you lost 10 points (round numbers) on the remaining shares. This equates to a loss of $2,000 (10 points X 200 shares).

So, net net, you lost $1,000 this trade (a gain of $1,000 less a lost of $2,000). This equates to 1% loss--half of the original risk. Therefore, even though this loss initially might seem catastrophic, it only comes to a 1% hit. You're shaken, but not stirred--at least you're still in business.

As you can see, its important to keep risks in line because you never know when you're going to get hit.

On Friday, the Nasdaq generally worked its way higher. This puts it just shy of multi-year highs.

The Ps ended higher too. This action keeps them at 5-year highs.

So what do we do? It doesn't take a rocket scientist to see the big blue arrows continue to point up-/and if it did, I pretty much got that covered too.

As far as setups, since the methodology requires a pullback, there aren't that many meaningful setups. Remain patient. On the next pullback we should see a plethora of setups.

Best of luck with your trading on Monday!

Dave Landry

dave@davelandry.com

P.S. Reminder: Protective stops on every trade!

P.P.S. If you would like a free trial to my trading service, click here.