By Owen Trimball – One of the attractive things about trading the stock market is, that when looking at a chart of the stock, it is known to have reliable patterns which most of the time are good predictors of future direction. Whether it be a “head an shoulder” reversal pattern or simply riding the directional momentum on the basis that “the trend is your friend”, a good trader can do very well – and with the availability of leveraged instruments such as options and CFDs, can earn a very good living.
In fact, it has been said that one of the most profitable skills you can ever master, is the art of trading.
But every so often, the market does the unpredictable. It makes a strong move in the wrong direction, just when all the signs looked like it should go the other way. This is usually due to some news item that has been released and the market, in its usual efficient manner, reacts accordingly. If the news is sensational enough, the investing public can behave quite irrationally, driven by fear (if it’s bad news) or greed (if the news is positive). The momentum of the price move takes on a life of its own and continues until it either blows itself out, or in the case of a downward move, fear is replaced by the perception that a bargain is on offer.
While markets are moving in predictable directions based on well established and generally reliable price patterns, all seems well. It’s the unexpected moves that come out of left field that a disciplined trader needs to be prepared for.
So let’s take a look at the three most common mistakes traders make, which separates those who make a lot of money from those who end up losing it all.
1 – Bad Risk Management
It is critical before you even think about trading, that you have a risk management plan. You have a certain amount of capital to trade with and it is essential that you preserve it intact, otherwise you’re out of the game.
One of the most common mistakes is investing too much on any one trade. You might feel very confident that price direction will go as expected, but this could be one of those exceptions already mentioned. You either lose a large percentage of your available capital, or you get stuck in a trade, hoping it will turn around – and in the meantime, miss out on all those other opportunities that could’ve made you some great profits.
So it is essential to only invest a small portion – no more than 10 percent but preferably 5 percent – on any one trade. This is particularly the case if you’re using leveraged instruments such as options, futures or CFDs.
Losing 20 percent of 10 percent of your available capital traded on one trade is the equivalent to only 2 percent of your entire trading bank. Psychologically, this is easier to handle. But the law of averages will mean that you also have other capital available for other trades whose profits will far outweigh the loss on one bad trade.
2 – Staying in Too long
Once your trade has realized a target profit, it is far better to close out a trade and bank the money, than hold on in the hope that it will make a lot more. Too often, the good fortune will reverse without notice and your unclaimed profit will turn into a loss. You need to develop a mindset that, even if the trade were to blast off into stellar profits after you exited, that at least you can be content that you achieved some of it – and that the strong movers are more the exception than the rule.
The above is especially true with the likes of short term option trading. Better to take 30 – 50 percent profit on a good trade than be disheartened when your leverage turns around and works against you because you stayed in for too long.
3 – Not Having a System
When trading the markets you can’t afford to make emotional decisions. In the end, you must realize that it’s only a numbers game. The first mistake a lot of traders make is approaching the market without any plan in place. You must define the aim of your system. Do you want to trade the extremes of ranges, or do you want to catch trends – or both? What success ratio do you need to be profitable? In connection with this success ratio, what must your percentage profit be in relation to percentage losses on any one trade for your success ratio to work?
What indicators or form of analysis will you use? What time frame do you wish to trade – day trading or longer term? Once you decide this, what chart periods will you focus on – 5 minute, hourly, daily or weekly?
If you don’t have a plan of your own, it would be wise to follow someone else’s trading system, providing it is tried and tested over years and is known to achieve consistently profitable results.