There are a wide variety of mistakes you are likely to make while learning to trade, but there are three mistakes you had better learn to avoid very early in your trading career. Before you start trading you must verify your trading strategy works by testing it both historically and on real-time data. Controlling the size of your losses is essential and without sound risk management you’ll never trade successfully. But controlling losses is not enough; you must also resist the temptation to over trade. Any of these three mistakes can be fatal to your trading success.
Trading untested ideas
Poor analysis or research is common among new traders. You may hear a news report about a particular company and decide it would be a great idea to trade the company based on the report. Unfortunately by the time the news gets to you many other people already have the information and have made their trading decisions. There’s a saying in the stock market: ‘buy the rumour, sell the fact’, meaning that when the news is finally released it’s very often too late to enter a trade. Following tips or rumours is a sure sign that you haven’t adequately prepared to enter the market. By doing your own analysis you can determine what works and what doesn’t.
Back test or forward test your trading idea before ever entering a trade. Back testing involves testing your idea on historical data and allows you to test a large number of ideas very quickly. For example, you may scan a lot of charts and identify a particular pattern that appears before significant moves in a share. This is back testing.
Forward testing (often referred to as paper trading) involves testing your idea on current data as it becomes available. To verify that your idea works, look for opportunities as they unfold because your chosen pattern may occur without a strong move following it. This is using forward testing to confirm your idea. Forward testing is more reliable than back testing, but much slower to perform.
In its simplest form you can back test by looking at lots of charts so you can begin to recognise patterns that occur before a strong move unfolds. When I started trading I studied thousands of charts to find out what worked and what didn’t, then narrowed down a few ideas to follow through with forward testing to see if they continued to work. Ensure you complete a thorough analysis before entering a trade, or follow a more experienced trader’s strategy.
Allowing losers to get out of control
Failure to cut losses can quickly result in disaster for any trader because the market can move far more than you expect. This is probably the most common mistake we see new traders make. The trader hopes the trade will reverse direction and move back into profit. Refusing to take the loss, the trader continues to hold the trade while willing it to turn into profit. While this may happen occasionally, when the trade doesn’t turn around it can do severe damage to your trading account. Cut your loss and look to re-enter if another entry signal appears. Ensure you develop the discipline to enter a stop loss into the market every time you enter a trade. This ensures you never get hit with large losses.
Mental stops are stop-loss orders that you place in your head instead of the market. For example, you decide to exit a long trade at $3.10, but when the market approaches $3.10 you convince yourself the market will move higher soon so you don’t take the exit as planned. The loss can now get seriously out of control and you could lose a lot of money. The problem with mental stops is you have to act on them. This can be difficult because when you are required to execute the trade you’re often in a losing position and hoping things will turn out ok. Even if you have been able to develop the discipline to act on your stops, the market sometimes moves very rapidly and you may end up losing more than you expect.
Mental stops may be used by experienced traders, but must never be used by beginners. Until you master the discipline to take exits when they’re signalled, stay well away from mental stops. Focus on good stop placement to avoid getting stopped out.
Overtrading
Another common mistake traders make is overtrading. It’s possible to make very nice annual returns from just a few good trades a year. High frequency trading is not required to make a profit. If your strategy has a sound edge then the more opportunities you have to trade it the better, but don’t confuse trading a lot with trading successfully. A few good trades can make a good year. It’s not necessary to be in and out of trades 20 or 30 times a day to make a profit.
Some of the most valuable time you can spend is identifying the best opportunities. There are millions of trading possibilities. It becomes necessary to make some choices and narrow your selection of what you will trade. To do this it’s necessary to overcome the fear of missing out on an opportunity. Remember the opportunity of a lifetime comes along every week! Many great opportunities will appear, so stop wasting your time and money on half-rate opportunities. Accept nothing less than the best when selecting trades. This
more selective approach can dramatically improve your profitability.
Eliminating mistakes
Eliminate these three fatal mistakes we’ve just discussed and your trading will improve dramatically. However, to eliminate the mistakes, first you must identify when you’re making a mistake. Your trading diary where you record your trades, wins and losses allows you to identify areas where you’re failing to stick to your plan. In particular be honest about the reasons you entered a trade. This honesty may take some time to develop because it’s not nice to admit you took a trade because you wanted to make back the money you lost in the morning. It’s easy to justify that a setup was in place, but tell the truth. You’re only lying to yourself.
Identify why you fail to stick to your plan and what you must change to eliminate the mistake. If the reason you fail to execute the core skills is emotionally based then monitor how you’re feeling when you’re trading and notice when particular emotions appear. Address each bad habit, one at a time, to change your behaviour.
Refining your trading skills takes practice to improve on the areas in which you’re weak, but the rewards are worth the effort. Becoming a better trader requires you to become a better person. This is one of the reasons you can find trading challenging to learn. Fortunately once you’ve changed a few habits, successful trading becomes much easier.
Jeff Cartridge
Education Manager
