In this article the author looks at the Seven ‘Sins’ of Trading and what action we can take to avoid them.
By studying at the most frequent reasons for failure, we can avoid making the same mistakes as the crowd, and thus turn these negative points into positives. In this article, I will be looking at the seven most common mistakes I see made by traders.
Mistake Number One – Switching Strategies
or "The Hunt For The Holy Grail"
The holy grail of trading – we’ve all looked for it – the super system that never loses. We’ve searched forums, read books, been to seminars, discussed in chatrooms, but the secret system that wins every time continues to elude us.
Why do we waste so much time and effort searching for something that doesn’t – cannot even – exist? Because it’s far easier than facing up to the reality that trading isn’t quite as simple as buying when a magic indicator says "buy" and selling when it says "sell", and watching the endless profits roll in.
Actually, it is almost a simple as that, but we’ll come to that later. For the moment, the important thing is, that there is no holy grail-always-wins trading system. The grail hunt is a highly destructive behavioral pattern that affects almost every trader at some point in their career. Typically, the trader starts by learning a system or strategy, and trading it for a short period of time. The strategy may prove profitable almost immediately, or may incur an early loss. Either way, sooner or later a loss will happen, and equally inevitably, a run of losses will occur together. At this point, the trader decides that this is not the system for them, and heads off in search of a new method.
In jumping from system to system in this manner, the trader never gives a strategy time enough to prove itself over the long term. All systems involve some losing trades, that’s the nature of the markets, but as long as a strategy has positive expectancy overall (that is to say, it will on average win more than it loses), those losses are of no importance.
Action: As traders, we must accept that fact that losses are to be expected, and stick to our chosen system for long enough to prove or disprove its expected long-term outcome. In doing so, we break the grail hunt cycle and overcome one of the biggest obstacles to our success.
As a final note on this subject, I want to add a word about forums and chatrooms. Whilst these are undoubedtly excellent sources of information and ideas, they can be very dangerous in fueling the cycle of strategy jumping. The nature of these resources means that they continually offer new ideas, and to the trader that means new temptations. By all means test out or paper trade new ideas alongside a live strategy, but beware of becoming a forum-follower and re-entering that pattern of always jumping aboard the ‘next big thing’.
Mistake Number Two – Not Having a Trading Plan
"If you fail to plan, then you plan to fail". I don’t know who first said that, but it’s a very sound piece of advise indeed. Planning is something that is all too often overlooked by traders, and yet a well drafted trading plan is one of the most important tools for success and profit.
In talking to struggling traders, I am constantly amazed at not only how many don’t have a trading plan, but how many don’t even know what such a plan is. In fact a trading plan is quite simple, it’s a document that details every aspect of your trading strategy. It is literally a blue-print for your trading methodology.
What should be in this document? Here are the most important areas it should cover:
- Mission Statement – A defined objective for your trading; if you don’t know what it is you are trying to achieve, how will you know when you have achieved it? Having a well defined goal is essential to success in any venture.
- Pre-market preparation. Actions required before the market opens, setting up for the trading session, reviewing economic calendars, and so on.
- Trade enty rules
- Trade exit rules
- Money management rules
- Post market actions – trade logging and analysis.
As anyone who has traded in a live market knows, we must often overcome our natural emotional responses in order to execute our trades correctly. Cutting losses and letting winners ride can be easier said than done. By defining as precisely as possible, our criteria for entering and exiting trades, we have a reference that we can use to help us overcome these responses.
The trading plan should be kept at hand throughout the market session. When we see a possible entry coming up, refering back to our strict written entry criteria we can objectively look at the chart and make a informed decision about whether to enter or pass. The same applies to exiting, whether the trade is winning or losing. Over time, trading becomes almost mechanical and stress-free.
Action: We must have a written plan that defines all aspects of our trading, and we must commit to following it to the letter. Only by ridgidly sticking to our strategy can we honestly determine if any problems in our trading lie within the system itself or within our execution.
Now I want to talk about one aspect of planning in more detail – money management.
You’re probably thinking that’s a really really boring subject, but before you decide to skip this article, let me say that money management isn’t just about making sure you survive long enough to turn a profit, it can also open up whole new trading opportunities to you.
Mistake Number Three – Not Understanding Money Management
There are two distinct sides to this subject, and for some unknown reason, most people only ever talk about one of those – survival – or what I call classic money management. It is hugely important though, so let’s cover that right now.
The idea is simple; firstly, we have a pot of money to trade with. Secondly, as we have established, losses are a part of trading and so there will be times when the cash in that pot decreases instead of increasing. Therefore, it stands to reason that if we don’t manage that cash correctly, it is entirely possible that we lose it all and can no longer trade.
So the concept of classic money management is to trade in such a way that our losses do not disproportionally affect our ability to trade. An example will make this clearer:
Assume we have a starting balance of $5000. We want to ensure that we can survive in this trading game for at least six months – long enough to prove our strategy and ability, and to turn a profit. At its simplest, we could say therefore that the maximum we would allow ourselves to lose each day is $40. If we hit that limit, we would stop trading for the day. This would keep us "in the game" for our six months assuming the worst case scenario of losing every day.
We could expand this money management strategy to say that if we lost our maximum limit of $40 a day four days in a row, we wouldn’t trade on the fifth day of the week, and if we lost 3 weeks in a row, we wouldn’t trade the last week of the month, and so forth. If we were losing as badly as that, clearly something would be wrong either with the strategy or our ability to execute it and so these enforced breaks would offer a chance to step back and analyse where we were going wrong.
Assuming a $40 a day maximum loss, it stands to reason that we could not enter any trade where the possibility for loss was greater than $40 – to do so would be to expose our account to a greater loss than is permissible. So our daily limit gives us a starting point for calculating risk and reward ratios for actual trading setups.
Knowing beforehand the maximum we can lose in any one day or on any one trade gives us a huge psychological advantage in our trading, as well as keeping us in the game for long enough to allow our strategy to turn a profit.
There is as I mentioned, another side to money management – position sizing. Many traders will trade fixed position sizes based on the availability of funds. This is perfectly valid, but it means that when looking at instruments to trade, they are inherently limited in what they can trade. Dynamically adjusting the size of position a trader is willing to take in relation to the cost of the underlying instrument can open up whole new trading possibilities.
Action: In order to give ourselves the best chance of survival in the market, we must define clear money management rules for our trading, based on our available capital. Doing so will give us the added benefits of relieving the psychological pressure involved in taking losses, and opening up new trading possibilites that may previously have been thought too risky.
With our strategy, trading plan, and money management taken care of, we’re ready to trade! In the next article we’ll look at another error that too many traders make in their impatience to earn big profits.
Right – we’ve looked at strategies and planning, so now we’re ready to trade right? Wrong! At least, we’re not ready to trade live.
Mistake Number Four – Not Testing
Trading is a great business, it offers potential levels of income and freedom that most people can only dream of. So it’s quite natural that having got the groundwork out of the way, the novice trader is eager to get clicking those buy and sell buttons and see the profits roll in. But hang on – the preparation isn’t over yet!
Imagine for a moment that you decided you wanted to become an airline pilot. You spent time and effort researching the type of aircraft you were going to pilot, you read some books on how to fly, and one day you found yourself in the cockpit at the end of the runway. Clearly, without having actually taken some time to learn how to fly this machine full of passengers, trying to take off would be a disaster! So why is it so many traders believe they can read a book about trading and then leap into the market without first getting some experience?
If you were going for the pilots job, you’d take a training programme which would undoubtedly see you getting some no-risk experience in a flight simulator. This would give you the opportunity to make all of your early mistakes without crashing a few seriously expensive airplanes in the process.
As traders, we are very fortunate in that we, like airline pilots, can practise and hone our skills in a risk-free environment. Indeed we have the added benefit that we can simulate our activity with high degrees of realism at little or no financial cost at all.
I am of course talking about "paper trading". In the most basic sense of the term, paper trading means that we follow our trading plan exactly as if we were going to put real money into the market, but at the point where we would actually buy or sell, we simply make a note of the current price instead of opening a live trade. We would continue to manage the trade exactly as if we had real money in the market, and would exit accordingly, again writing down the exit price.
Going a step further from pen and paper, today’s internet-generation trader can take advantage of software simulators like TSim+, which imitate a live trading platform. These programs have the advantage of making the paper trading experience much more realistic; they also cannot be cheated in the same way as a note on a piece of paper, that is to say we cannot conveniently decide to erase a trade we later decide was a mistake!
There are some who believe that paper trading is not worthwhile as it can never reproduce the emotional stresses that are involved in live trading. Whilst that is true to a certain extent, I would argue that if you are not sufficiently proficient at executing your trading plan in a simulator, why would you be able to do so with real money?
Paper trading gives us a great opportunity to put into practise what we have learnt, test new strategies, and tune our skills with no risk. Once a trader can consistently show a profit on a simulator, they are ready to take the next step – live trading. Again, this is not something to be rushed, and again, like airline pilots we can work our way up to this.
Just as the pilot is probably not going to make his first flight in a jumbo jet, neither do we as traders need to take a full-size trade when we start for real. If trading equities (shares), we can buy and sell very small amounts at almost negligible cost. If trading futures, we can usually start with "mini" contracts which are valued at a fraction of the price of a full size version. Whilst this limits our profit potential as we take our first steps in the live market, it very importantly also limits our potential losses.
With the huge array of software tools available to us, along with discount brokers offering cheap trading instruments, there is no need for any trader to get seriously burned on their first outing into the market.
Action: We must commit to testing and practising our trading in a risk-free environment before putting our capital into the live market. Only when we can show consistent profit on a simulator should we move on to trading real money, and then only in small doses.
By now you might be thinking that this trading business requires somewhat more effort than you first thought. And you would be right!
Mistake Number Five – Not Putting In The Required Effort
It’s a strange phenomenon that seems almost unique to the field of internet trading; people believe that they can read a book, open an brokerage account, and start making huge amounts of cash just like that.
I used the analogy of an airline pilot in the last section, so lets continue with that theme here. Not many people would expect to decide on Monday that they wanted to fly long-haul airliners, buy and read a book on the principals of flight on Tuesday, and start work as a Captain on Wednesday. But with trading, such a short learning curve appears to many to be perfectly expected.
Whilst I certainly agree that, proportionally in relation to other activites day trading can provide much greater returns for much less effort, it nonetheless does require some effort to get going.
Trading, like any other skill, takes time and commitment to learn and become proficient. However, unlike many other skills, that time to become sufficiently adept need not be costly, or at the expense of existing obligations. In other words, a novice trader can learn the markets and practise their trading whilst continuing in their day-job, and without significant outlay.
Indeed I would advise any would-be trader to have a steady source of income when they start out. The absolute need to generate a profit can have a hugely detrimental effect on trading decisions.
A problem a lot of student traders I work with have is that they start out with a healthy dose of motivation, but when the going gets tough they start to lose interest. Suddenly it becomes too much like hard work. The first losing trades make for a powerful reality check. Motivation goes out the window, and plans to quit the day job are quietly forgotton about. Part of this problem is down to unrealistic expectations at the outset, and part is due to a lack of accountability. In a regular job, we’re normally answerable to someone. If something doesn’t get done, there’s usually someone higher up the food chain ready to kick our butts.
When we’re trading our own account, that concept no longer exists. We’re only accoubtable to ourselves. For many people that’s a first. The solution is to get back to that written trading plan. If the plan has been well thought out, it will include the all important mission statement, and perhaps a set of attainable goals. Re-reading these every day will help reinforce self-accountabilty and motivation.
Trading isn’t difficult, but neither is it an instant source of riches there for the taking. Like anything worthwhile, you get back what you put in. The difference between trading and other activities is that once you have mastered the skill, relative to the amount of time you spend "working" you will get back much more more than you ever put in!
Mistake Number Six – Overcomplicating It
It’s easy to get caught up in the details, but if we take a step back for a moment, trading really need not be complicated at all. Finding a strategy to work with can take as long or short a time as you like – there are plenty available off the shelf (including within my own course, naturally!) Formalising that strategy into a written personal trading plan is something that requires only a couple of hours of time up front – after that it can be refined and added to as you go along.
So already we see that very quickly we can get to the stage where we are ready to begin simulated or "paper" trading. And it’s at this stage where lots of traders really start to overcomplicate matters.
Earlier in this article, I talked about strategy jumping. A close relative of that particular problem, is strategy morphing. The cycle is very similar indeed. The trader starts trading their plan with all good intentions. Things may or may not go well straight away, but sooner or later as the markets behaviour ebbs and flows with and against the strategy’s strengths and weaknesses, losing trades will inevitably occur.
At this point, the strategy-morpher gets scared. They don’t like to give money back to the market, so they decide to try and modify the system to filter out trades like that last losing one. They begin to add indicators to charts, coming up with new ever more convoluted combinations, furiously testing to see what cuts out the most bad signals whilst leaving in place the good ones. A few times round this loop and their chart starts to resemble something a siezemologist might be more used to seeing than a price chart!
I’m not saying that modifying and testing of new systems and ideas isn’t valid, but when it’s done at the expense of trading an already profitable system, the trader ends up chasing his own tail, and loses out in the long run.
Remember that every strategy will have losing trades. When those losses are within the normal expectations of the system, there is no need to start fiddling. Stick with it and as long as the system has positive expectancy, the law of averages will see you through those drawdown periods and you will make money. Paper trading the system thoroughly beforehand will give you the faith in the setups to be able to do this.
Markets are complicated, but trading them need not be. Simple really is the best policy. A simple system makes for easier to spot entries and exits, a less stressful trading day, and consequently a less stressed and more profitable trader. Almost all of the successful traders I know have found this out the hard way, by trying the complicated route first.
Action: To avoid mistake number six, you actually need to do *less* work. Put in a little effort up front in the planning stages, and then relax and just follow your plan to the letter. Thinking too much can damage your trading, not to mention your stress levels.
Mistake Number Seven – Not Taking Action
For every trader who opens a brokerage account and starts placing trades, there must be a hundred more who had every intention of doing so, but for one reason or another, never actually took that step.
It’s a blindingly obvious statement to make I know, but you cannot make a profit from the markets if you don’t actually start trading them! Why do so many potential traders buy the books, ready the forums, and study the charts, but never actually place a trade? The most common reasons I hear are these:
Fear "I’m worried I’m going to lose to much money".
If you trade on a simulator, you can’t lose a penny. Today’s technology makes simulated trading more accessible and more realistic than ever. Having a go risk-free will either give you the confidence to take the next step, or will prove to you that trading really isn’t your thing. Either way, you’ve got nothing to lose by trying.
Time "I don’t have time to sit in front of a computer all day learning this stuff". There are stocks and futures markets in every developed country in the world. With the wonder of the internet, we can trade them all. That means that when you have some spare time, there is a market open somewhere. There’s no need to give up the day job to try out trading.
Money "I don’t have enough cash to trade with". As trading becomes ever more popular, and brokers try and reach out to bigger audiences, minimum account levels are falling. If you have a few hundred spare dollars (US), you can start trading. Having said that, never trade with money you cannot afford to lose. If losing your starting capital is going to put you on the streets, you really shouldn’t be trading with cash. However, there’s no reason you can’t paper trade while you save up that pot.
No Confidence "I don’t think I can do this, it’s not for me". If you really think trading is not your thing, of course there is no point in pursuing it. If however you simply fear that you won’t succeed for whatever reason, then you could be missing out on a great opportunity for nothing. Get yourself some free charts and a free simulator, or even a pen and paper, and have a go. If you don’t try, you’ll never know!
Action: Ultimately, only you can take the next step to becoming a profitable trader. It’s a sad fact that many who read this will never take their trading dream further. But those few that do, will be well on their way to success, profit, and trading freedom.
That’s the end of the Seven Deadly Mistakes. I hope you’ve enjoyed reading it as much as I’ve enjoyed putting it together.