The Sources of Trader Failure
Stockscores.com Perspectives for the week ending October 9, 2011
In this week's issue:
Trading is simple, but not easy. Despite its simplicity, most people who try to trade have a hard time finding consistent profitability. Trading well is as much about doing certain things right as it is about avoiding the common mistakes. Here is a list of the common causes of trader failure.
1. Lack of Knowledge
Trading does not have to be complex or involve a sophisticated understanding of capital markets. In one day, I can teach a person the skills that I use as a trader. However, like riding a bicycle, being good at applying those skills takes practice and usually involves some painful mistakes through the learning process. You probably were pretty wobbly the first time you pedaled a bicycle but, with time, you found your balance and got good at it. Trading is no different.
However, unlike riding a bike, there are thousands of ways to trade. You have a choice in what you trade, the hold period for your trades and the strategies you apply.
There are many options for people looking to learn trading. You can take classes, study online, read books or try to figure it out on your own. Each approach to learning has a cost; don't underestimate the price for how you intend to learn.
With so many approaches to acquiring the knowledge you need to trade, there is not necessarily just right and wrong ways to learn. It becomes a question of what is right for you, what best fits your learning style. What is most important is that you get educated before you risk a penny of your money in the market. Most people can't beat the market because they don't know what they are doing. Don't let a lack of knowledge ensure your failure.
2. Poor Risk Management
The focuses for most aspiring traders are the decisions to enter and exit the trade. They spend a lot of time trying to find the right stock to buy and then try to make a good decision on when to enter. They miss out on the most important component of the trading process.
Risk management is that often forgotten piece of the trading puzzle. Without capital to trade with, you have nothing to do. Protect your capital first and never try to get rich overnight. Some might get lucky in the short term but those who fail to manage risk over the longer term will go broke. That is guaranteed.
For every trade, you need to know your downside. Being wrong is part of trading so you must have a plan for what to do when you are wrong.
3. Insufficient Capital
Since being wrong is part of a profitable trading strategy, you need to allow for drawdowns of your capital base. There will be times when market conditions will not be great for the strategies you are applying.
When planning your trading business, you must allow for this potential deterioration of capital. You may make five steps backward before you start to go forward, make sure you have the capital to ride out these losing periods.
4. Trading Without Proven Strategies
I have seen a lot of people trade without a strategy that they have tested. They think that they can beat the market by doing things that make sense. This is often the biggest problem with people who are successful in other areas of life.
It is a bad idea to think that you can beat the market by being smart. The markets rarely do what makes sense, at least in the context of the information that we have. This is because the market often moves on information that most of us just don't have.
For that reason, it is smart to have a set of trading rules that you first test exhaustively before you trade. Your testing must determine whether the rules yield a positive expected value. Over a large number of trades, your rules should make a profit. What happens on any individual trade really does not matter.
5. Failure to Follow Rules
The rules you define and test are only effective if you follow them. While this is easy for all of us to understand, it is a very hard thing to actually do. We break rules because we are afraid of losing money. Emotion is a hard thing to overcome.
To minimize the impact of emotion requires a comfort with the risk you are taking. Most traders find that paper trading, simulated trading without using real money, is not too hard. It is only when they have their capital at risk that they start to make mistakes.
The solution to this problem is to not take more risk than you are comfortable with. The best traders are those who don't care about the money. The more you can do to take out emotion, the better your chances will be to follow the trading rules.
6. Lack of Determination
Doing anything well requires the determination to learn and gain expertise. This is very much the case for trading because it is such an emotional pursuit. There will be times when the novice trader will feel overwhelmed with emotion and ready to give up.
I don't think trading is something that can be done well by someone who does not like it. Having a passion for trading is what will get you through the hard times and ensure that you stick with it when your heart may tell you otherwise.
7. Poor Focus
The shorter the time frame you trade, the more focused you need to be. Position trading (hold period measured in weeks or months) is not that demanding mentally because you have a lot of time to make your trading decisions. Swing trading (hold period measured in days) requires you make quicker decisions but is not as demanding as day trading. The day trader (hold periods measured in hours or minutes) has to make decisions in only seconds and work hard to not miss out on good trading opportunities.
It is hard to trade if you have a lot of distractions while you are trading. You have to do what is necessary to avoid letting outside factors have an effect on your trading decisions.
8. Inability to Adapt
The market is constantly changing and you need to be able to adapt with it. That means applying trading strategies that are appropriate for the present conditions; you may not want to apply a buying strategy in a market with strong downward momentum.
Avoiding chasing the market with your rules is a challenge that many traders have trouble with. You should have a set of trading principles that do not change over time, these based on source of opportunity that you are pursuing. Do not constantly change the rules of your tested and proven strategies.
However, how and when you apply your strategies will change as the market evolves. I keep a stable of trading strategies that I apply as conditions warrant.
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If you are a long term trader, you should be mostly in cash right now since the market's volatility shows a lot of uncertainty. However, that uncertainty presents a good opportunity for swing traders willing to hold positions for just a few days.
Right now, the price trends are only a few days long. That means trading requires a watch of the intraday charts using the actively traded ETFs. These include the SPY, SDS, SSO, QQQ, QID, QLD, VXX, DIA, EEM, FXI, XLF, FAZ and FAS. In Canada, the T.XIU, T.HGD, T.HGU, T.HEU, T.HED and T.VXX. Multi day trades on these ETFs can yield reward for risk ratios of greater than 10.
I think the market is more likely to go lower than higher next week so I think a focus on the following ETF trades is a good approach. Monday trading will be important to confirming whether the next wave is down, but Friday's action indicates that is what is probably going to happen.
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1. VXX
The Volatility Index moved up on Friday, ending a three day downward move. The VXX is now back to its daily chart upward trend line. The close above the upward trend line on Friday should lead to a continuation of the upward trend. Look to the 15 minute intraday chart for a signal to buy. The VXX trades in Canada as T.VXX but the Canadian market will be closed on Monday.
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2. FXI
The Chinese market is performing worse than the US markets, this ETF allows you to participate in that weakness by going short. After three up days, the FXI closed down and below its open on Friday, setting up for a few more days of weakness. Watch the intraday chart for a confirming signal to go short.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
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in the stocks discussed above and may trade in the stocks mentioned. Don't
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