Paul spent the next month paper trading various Stocks using the technical analysis and swing trading strategies Peter had taught him. He had some degree of success with it, but he was still losing money on far too many of the paper trades he was taking. He wasn't sure why, but he was determined to find out what he was missing at his next meeting with Peter.

Peter met Paul at his home for their next meeting. Paul lived in a quiet neighborhood in a neat, three bedroom home with his family. His office was a room that he had converted from a small bedroom - it was cramped but usable, and contained a desk, two chairs and a sofa. The office window looked out over the gardens Paul's wife had lovingly planted over the years and the room felt light and airy as the two men entered.

"So, what have you been up to?" Peter asked as they sipped their coffee. "I have been paper trading since our last meeting, but to tell you the truth, I haven't made a lot of headway," Paul replied.

"Let me look at some of your trades," Peter said.

Paul opened up his charting software and went through his most recent 10 trades as Peter looked on. Once he was finished, Peter knew the problem.

"You followed the rules on most of your trades, but your stop loss placement is the problem. Let's look at one of these trades in detail. Bring up a chart of EBAY."

Paul opened a chart of Internet Auction Company Ebay to look at three of his recent unsuccessful trades.

Source: Incredible Charts - www.incrediblecharts.com.au

"Your entry into this trade was good," Peter continued. "You waited for a higher swing high (Point 1), then a higher swing low (Point 2), then entered long with the new trend. The previous down trend line had been broken and the moving averages had crossed, so the three criteria I use for a long trade had been met.

"Unfortunately, you placed your stop loss order too close to the market and were stopped out of the trade just 4 cents from the low the next day because you used 20 cents below the swing as an exit (Point 3). This Stock has a history of forming swing lows and then breaking them by up to a dollar before continuing on with the trend - you have to expect this and allow for it in your trading strategy.

"You entered again after the next higher swing high (Point 4) and placed your stop loss below the swing low at 30.63 (point 5), only to see the rally fail the same day and stop you out again.  This time the Stock broke the swing low by 50 cents (Point 6) before recovering.

"The next swing high was above the previous one (Point 7) so entering after the next reaction was a valid setup. The Stock gave you your entry signal, rallied a little more (Point 8), made a higher swing low and then broke it again (point 9), stopping you out of this third trade in a row with a loss. This is a very frustrating price movement to try to trade. 

"Using close stops in this situation is bound to cause a series of losses. The key then is to understand that all trends are not created equal, and to have a mechanical system of identifying potentially strong trends and only taking positions in those that offer the most promise. Then, determining where to place your stop loss order so that the market has to change trend to take you out of the trade.

Peter's Solution...

"I will share with you how I trade moves like this. Every trade I take uses this same basic strategy - I do not like being stopped out of high potential trades, so I take a different tack to most people who use swing charts to determine where they place their stop loss orders.

"When entering on the initial higher low of a potential new uptrend such as this (as the Stock rallied from Point 2), I place my stop loss order at least a dollar below the swing low, and preferably below the previous swing high, in case there is a secondary reaction and the Stock price falls slightly further than the first swing low. 

"Only when the swing high (at Point 1) is taken out, or the reaction reaches 4 days, do I move my stop loss order up to below the swing low that was formed at the end of the initial reaction or the low of the 4th day down. 

"If this initial reaction exceeds 4 days, I usually abandon the trade, as that is the time filter I use to determine whether the move has the potential to turn into a strong trend or not.

"A reaction of less than 4 days, when a Stock is in this position, usually means that the rally will have some more upside. A reaction that is accompanied by decreasing volume is especially bullish, as it often means that the sellers are exhausted and the buyers are about to push the price significantly higher.

"So, lets paper trade this recent rally using these new rules.

"We have a valid buy signal at $29.10, 5 cents above the daily high of the first reaction. We buy the Stock and place our stop loss order below the previous swing high at say $26.60. We adjust our position size so that our exposure if we are stopped out at this price is no more than 10% of our total Trading account balance.

"The Stock rallies to a new high, so we move our stop loss order up to below the swing low formed at Point 3. The rally continues to Point 4, then has a three day reaction (down to point 6) before moving higher again. As the Stock rallies, we move our stop loss order up to protect our open profits to below the low of the three day reaction at point 6.

"We now cannot lose any money, barring a catastrophe. We trail our stop loss order up below the major swing lows until we are stopped out. Currently we are still long this Stock and holding a good profit, instead of being stopped out three times for a loss."

"By using this strategy, you will find yourself in far more winning trades and will get stopped out much less. Of course, the losses will be bigger when you do get stopped out, but they shouldn't ever exceed 10% of your trading capital, which is only a small part of your total investment capital, as you have the bulk of it invested in Index Funds for the long term.

"Speaking of that, do you remember what I said to you at our first meeting?"

Paul thought back to their first meeting and remembered that Peter had told him that he placed 70% of his Stock market investment capital into Index Funds, and only traded with the remaining 30%. This gave his portfolio long term stability while allowing him to make substantial profits on some of his funds.

"You told me about how you invest in Index Funds and only trade a small part of your account. So I need to look at my asset allocation and do the same," Paul replied.

"If you want my advice, take 70% of your remaining capital and invest it in an index fund with one of the large Fund Managers. Then, get yourself a margin loan and use the remaining 30% with a small amount of leverage to trade Stocks. Never go over 50% leverage when using margined funds though, and of course, never risk more than 10% of your trading capital on any one trade.

"What is the current trend of the S&P 500 Index?" They pulled up a chart and looked at it together.

Source: Incredible Charts - www.incrediblecharts.com.au

"It going down," replied Paul. 

"OK, so you want to be in a fund that makes a profit from a down trend in the Index then, don't you?" Peter asked. "Yes, so what do you recommend?" Paul asked. "I use several Fund Managers because I have a large amount invested, but if you use any of the top three you should do alright. 

"Just remember, you are not to just buy a fund, hold and hope with this portion of your capital; if you get a sell signal using the moving average crossover system I shared with you, you sell your position and switch to units in an Index fund that profits from an uptrend.

"Please remember though, I believe we have seen the low in this bear market, and while I still have 70% of my capital invested in funds that profit from a down trend, I am looking for a reason to buy this market. Therefore, if I am right, you may be switching out of the short fund and into a long fund in the near future.

"But for now, we just have to go with the trend. So where do you think would be a good place to enter a fund looking at this chart?"