Introduction
One of my favorite quotes came from the German poet named Heinrich Heine, and goes like this:
Experience is a good school. But the fees are high.
Although quite poetic, one hasn’t got to be a poet to understand the meaning. Within the trading context, every trader is set to receive some hard lessons sooner or later. In fact, the market is known for showing mercy. The fees of these lessons will, most likely, be high and, again most likely, the lessons will be repeated time and again. We, at The Trend Chartist, don’t want our readers to paying big fees to Mr Market. Therefore, below you will read about the 5 most common mistakes that traders make and how to avoid them.
1. Trading Without A Plan
This is particularly common in novice traders. These individuals are most likely influenced from movies like The Wolf of Wall Street or pseudo-trader culture. Therefore, they tend to just jump into trades with no actual trading plan, move stop levels impulsively, reinvest in order to lower their average price on an emotional state, change strategy (if they ever had one) mid trade, take profits early, to name a few.
Having been in this state (fortunately not for too long), I think I would attribute such behaviour to gambling. Since markets move upwards over time, gambling on “low risk setups” may pay out sometimes, which fuels the gambler’s instinct. The other reason could be related to the “easy money” culture, which, by the way, has nothing to do with trading.
So how to avoid being that type of trader? Simple: Create a set of rules pre – trade and stick to them, even if the world is falling apart. That last notion doesn’t imply that one shouldn’t update their trading systems, every once in a while, in their effort to make them better. On the contrary, by writing down their trades, traders can easily spot systemic or execution errors and can be corrected relatively easily. A very intuitive trading journal that we recommend is Trader Sync. Give it a try. Trade recording literally saves fortunes.
2. Risking Too Much Per Trade
A surprisingly large number of traders seems to have difficulty understand a very basic mathematical principle: If you divide a number with two, you need to multiply it with two to arrive at the initial figure. In trading terms, a 50% (paper) loss needs a 100% come back just to be equalized. From a trading account standpoint, this will usually mean adding more funds.
The reason that this happens is that, again, many traders are sentimental. When they encounter (what they think to be) a very strong setup, they’re willing to commit 20%-30% or even more of their trading account to that particular trade. On top of that, they’re willing to withstand paper losses of 10%-15%, waiting for that bounce. This practice may increase the account drawdown substantially, which will eventually lead to huge losses down the road.
A good rule of the thumb to tackle this issue is not to risk more than 2% of your total account value per trade. For example, assuming a trader who has a USD 100k account and wants to enter a specific trade, the stop loss should be set at USD 2,000. The question that rises is how to calculate a position size that isn’t too big? A good rule of the thumb is to divide that maximum potential loss with the currency distance to that stop loss. For example, assuming that stock XYZ is trading at USD 50. Our trader has identified a trendline at USD 47.5. They also read our Bollinger Bands vs ATR: Which One To Use And When article and want to allow another USD 0.50 for volatility reasons. So, they want to set their stop loss order at USD 47. How big should their position be? We can answer this question by dividing USD 2,000 (max account risk) with USD 3 (distance to stop loss). The trader shall buy around 667 shares of XYZ, because should the trade go south, they won’t risk more than USD 2,000 (3*667). In this way, the trader knows their maximum outlay before entering the trade, which, though, takes us to common mistake number 3.
3. Moving The Stop Loss Order
When a trade has gone south but somehow the stop loss order hasn’t been executed, it is quite common for inexperienced traders to move it lower (or higher for short sales). This practice throws all the previous planning out the window. The initial stop loss order was put at a specific point for a reason: A price pattern bottom, a trendline, X-times the Average True Range, or Parabolic SAR. It wasn’t placed there arbitrarily.
The moment a trader succumbs to this temptation, they are putting themselves in great risk. One big loss from a trade like that could erase weeks of disciplined trading. The solution is very simple: Stick to the initial plan and re-evaluate it later.
4. Overtrading, AKA The Addiction Trap
Many traders seem to fall for the concept of direct scalability. They think that if they’ve made 5 trades in a month, 4 of them with a profit, they could scale this by doing the same amount of trades in a week. However, this couldn’t be farther from the truth. A key part of successful trading is a cool-off period. It is the period that the trader, not exposed in the market, has the time and the necessary peace of mind to examine their TraderSync journal, identify trading patterns that don’t work and apply corrections. If the trader is always exposed into the market, he cannot easily remain on top of the situation.
Adding to that, many traders seem to initiate trades out of boredom. This practice has the potential to literally destroy a trader’s account, as mistakes 1, 2 and 3 go out the window. From a differentiation standpoint, the average novice trader has a limited knowledge of their investment vehicles. They may be watching the S&P500, or some tech stock universe, which means that there’s a high chance all of their trades to carry increased risk of correlation.
Last but not least, we have the trader who is entering a new trade right after an unsuccessful one. Revenge trading can lead to poor decision making, based on poor price patterns and oscillator indications. A very entry level mistake is to just weight for the RSI to reach overbought or oversold levels and just enter a trade in the opposite direction. In our article RSI: Top 5 mistakes of the novice trader we explain why this approach simply doesn’t work.
How to prevent over trading? One way is to set a maximum limit of monthly trades. I know, it sounds counter intuitive but, trust me, over the long run you will be benefitted. If this seems too harsh for you, you can set a maximum limit, together with an allowance buffer (+/- 1 trade). Another solution would be to set a daily or a weekly trade cap. Finally, you can set a cool off period after two consecutive losing trades.
5. Trading Outside Market Context
“The S&P 500 has been rising for too long now. Everything is in overbought levels. It has to reverse at some point!”
Now, tell me if you haven’t made that thought even once….Liar!
It seems that what we would call “mean reversion strategies” are well embedded into the novice trader’s psychology. However, market modes are relentless. And one better know in what market they invest. If a market is trending strongly to the upside, it would be a far safer strategy to ride the trend, place a trailing stop loss order and harvest the profits, than trying to find the exact reversal point. And if this happens by chance at some point, chances are that the novice trader will exit their trade before the broader trend also changes. In other words, trading outside market context means that one is aiming for the small gains while they neglect the potentially much larger ones.
How to tackle this behaviour? Always check the technical picture on multiple timeframes. What appears as a pullback in a 1h chart, probably hasn’t affected the daily chart and so on. In fact the other way around is much more reliable: Identify a potential trade on a higher timeframe, then confirm in a lower timeframe. Only if the technical picture (price patterns and indicators) in multiple timeframes are in line with one another, we have a situation worthy of examining further for a trade.
Bottom Line
In the previous paragraphs we described the top 5 mistakes of the novice trader and provided ways to fix them. While these are simple fixing solutions, the majority of traders has a hard time incorporating them into their trading decision process. It seems that most of them think that trading is easy money. Well, I got news for you: It isn’t. And the moment a trader gets their head around that truth, they will start becoming a better version of themselves.
