Ask Colin

Please comment on my trading system.

You have asked a very complex question that raises a lot of issues. Let me deal with them in turn:

I trade breakouts from consolidation patterns or continuation patterns, using a stop loss 3% below the line of resistance.

This sounds alright to me. It is a valid use of the technical analysis concept that a resistance level, once penetrated, should become support. 3% sounds rather close to me, but if you are doing well with it, I would be inclined to stick with it. Later, you mention increased market volatility being a problem. Many traders deal with this by using a volatility measure like Average True Range for their stop, rather than a straight percentage. It is more complicated, but it does take volatility into account.

My money management rules vary my position size depending on the trade risk, as per guidelines provided by the Australian College Of Trading. Generally risking about 1% of my total equity.

I am not aware of the Australian College of Trading rules, but I assume they are the basic ideas taught by Elder, Tharp and myself. I also use 1% of trading capital for this purpose, but do not take brokerage and slippage into the calculation to keep it simple. Others use 2%, but factor in brokerage and slippage. The end result is usually similar, so I stick to the simple method.

I also 'calculate' a target price, either from resistance levels on the chart or from the prevailing chart pattern and only trade when the profit risk ratio is greater than 2. This has excluded some poor and good trades alike.
I think what you are doing is sound. I am not surprised at the result - that is the nature of trading. All you are doing is trying to put the probabilities in your favour. However, there are no absolute guarantees.

My selling pattern is to sell half my position at the target and the remainder when the trend line is penetrated by 3%, resulting in some very profitable trades.

Good. However, without intending to knock your good results, the real point in trading is not just the good trades. It is the net result of your trading for a period that is the only test. You have to net out the wins and losses and see what you get. Otherwise it is like a golfer saying he played 15 great holes under par. You think he has done well, unless he tells you he was 20 over par on the other three holes!

With such aggressive stop loss prices I have been very quickly stopped out of 3 of the 4 positions I have taken since Sept. 11 , which have subsequently turned, due to the increased market volatility.
Stop losses are there to prevent catastrophic loss. Again, the only test is how you have done for the period overall. I have commented on volatility above and how your stops might take it into account. However, bear in mind that volatility is a two-edged sword. On the one hand it represents profit opportunity - you need price movement to make profits, so theoretically the more volatility, the more profit opportunity. However, on the other hand, volatility is also a measure of risk. Many traders welcome volatility, but others run from it and wait for orderly markets. My sense is that increased volatility is a warning. Consistent trends are much easier to trade safely.

I am considering moving my stop loss points to the centre or bottom of the consolidation pattern, depending on the width of the pattern.

I understand the bottom of the trading range (but below it, not at it) based on the concept of support. However, I have never understood the behavioural basis for the mid point stop. I don't know what you mean by "depending on the width of the pattern". I would have thought that the width was independent of the rationale for your stop.

This will however make it impossible to comply to the profit to risk ratio rule and will also modify my exit process.
Since the stop loss is the exit point, it is self-evident that it modifies your exit at a loss. However, it should not alter your exit based on the target or on the trend line. On the profit to risk ratio, I would have thought that it just means that you will be much more selective about the trades you take. As Lenin said about politics, so with the trading plan: Everything is connected to everything else. What you are putting your finger on here is the basic problem of risk and money management. Reduce risk in one way and it increases somewhere else. It is about finding a balance or a "trade-off" as the Americans put it. You cannot have your cake and eat it too - in trading as in life. You need to strike a balance that fits with your objectives and risk profile. Only you can think it all through. Then test it thoroughly to make sure it works the way you want.

In your last newsletter you quoted a respected trader's advice not to put more than 10% of equity into a position. I am therefore considering taking a
position of 10% of equity provided it does not risk more than 2% of said equity.

For me, those are quite aggressive strategies. I think you could get away with it providing: (1) You make sure your ten positions are as diversified by industry sector as you can. My preference is for about twice this diversification. However, everyone's risk tolerance will be different, depending upon their age and situation. (2) Your 2% rule includes brokerage and slippage. Otherwise it could get to be nearer 4 to 5 % in reality.

With respect to you intelligence and without saying you are doing this, beware of the traps I see lots of people make: Firstly, they see a limit like this and only see 10%. They just ignore the words "NEVER PUT MORE THAN", which, to me implies that this is an upper limit for the very best investment opportunities. I can give you a written guarantee that these people rarely go to their limit. Most will be less. Secondly, they fall into the trap of hubris. Philip Caret was an investment genius. He is one of the rare greats. Most of us can only dream of being as good as he is. Until we prove we are that good, it is prudent to take less risk that the great investors take, because they know what they are doing.

My disquiet comes from reducing my criteria for entering a trade from a system, which has been successful up to now. I am currently doing some back testing on past and potential trades, to see what effect this may have on profits and would appreciate your thoughts.
There is only one rule here. You take you existing system and measure its results - in practice, but on paper if you don't have several years experience with it in both bull and bear markets. Then you paper trade your new system and see if it beats the old one. If not, forget it, or change it and test it again. If so, start to test it live and if it continues to perform, gradually increase the money you apply to the new versus the old system.

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