Avoiding Common Pitfalls ( Advertorial 7)

Most markets have predictable trends and repeated patterns. Why? Because most things that happen in the markets are a results of the motivations of the people in those markets.

Many people say that what drives most markets are greed and fear. Greed makes people buy, and fear makes them sell. Greed and fear actually benefit traders: Greed, or at least the desire to make money, is why we trade in the first place. Fear is a healthy response when we sense danger or disaster closing in, and it motivates us to get out of a bad situation.

But when they get out of control, greed and fear are two of the basic psychological pitfalls that make traders fail. Traders who consistently make mistakes usually do so for one or more of the following reasons.

Excessive Greed

The desire to make money is what motivates us to become successful traders in the first place. But the desire to succeed is different from trying to get every possible profit from a trade. This kind of reckless greed makes traders hold on to their positions long after the downside has started to outweigh the upside and risk outweighs potential reward.

Here's an example: a trader sees that a particular stock is starting on a run; it's reported good news and is already up 20% for the day; the volume is still building; it's stable at the current price; the market is rallying strongly; and it looks like it will go higher. The trader buys 1,000 shares at $6 a share. By 12:15 P.M., the stock has raced up to $10 — a gain of over 66 percent for the day, and a profit of $4,000 on 1,000 shares.

The trader knows that round number price points, like 10, are psychological barriers for traders, and that if a stock is going to stop rising, it will probably be near a point like this. As it turns out, after momentarily shooting to $10.03, the price stops rising and starts to go down. The trader knows that he should sell now and re-buy later, but he keeps thinking, “What if it goes to 12 before it stops? What if it makes a 100% gain? How will I ever forgive myself for missing out on another $2,000 profit because I sold too soon?”

So, of course what ends up happening is that the stock drops down to $9.50 and then $8.75, ending the day at $8.90. The next day the market opens down and the trader is lucky to get out at $8.70, down $1,300 from the profit he could have had.

The way to get around the lure of excessive greed is to take profits consistently. It doesn't matter if the stock goes up another dollar or two after you're out of the position. The important thing is that you've made a clean profit and are ready to go on to the next trade with even more capital than you had before. And going on to the next trade is better than staying in the old one once it's gotten too risky, because the next trade will have an upside that outweighs the downside. (If it didn't, you wouldn't have any reason to get into the position in the first place.) The old trade's downside has begun to outweigh any further gains you're likely to make.

What should you do?


1)Lock in profits. You may miss a few highs, but you’ll stay consistently ahead.


2)Set your goals for solid gains, not the maximum possible gains.

Excessive EgoBig egos cost thousands of people millions of dollars in the year 2000. An inability to admit a mistake causes many people to refuse to take small losses on a bad trade. Why do traders resist taking small losses so they can move on to better trades? It's because they don't want to admit that their decision to get into a position was unwise. They don't want to admit that they were wrong about the stock, bond, commodity, or currency.

Here’s an example: A trader buys 500 shares of a stock at $20 per share, investing $10,000. He believes that the concept behind the company’s innovative new software is going to be the extremely successful, and he's seen a lot of reliable information that backs up this idea. The price has recently moved up steadily, from 16 to 20, so it seems the market shares his belief.

For some reason, though, the new concept is slow to catch on. The trader holds the stock for three weeks and sees its share price remain essentially the same as where he bought it. It goes up a dollar, down a dollar, and so on — it's trading in a range and doesn't show any signs of movement. Then the market trends downward and all the tech stocks go down. His stock doesn't fall quickly, but over the next couple of weeks it gradually sinks back to $16 a share. There's no sustained volume, and it seems that no one is interested in the stock.

The trader insists that if he just keeps holding the stock it will not only recover but bring him a large profit once the rest of the market realizes its value. He holds the stock for the next five months, watching it move up and down between 15 and 16. Finally, after more than six months, the stock goes on a run — up to 22. The trader does the right thing and takes profits at this level. Now he can have the last word with all his friends, who were sure he would never make money on the stock. He gets to say to everyone, "I told you this stock would be hot."

But it doesn’t matter. The reality is that the trader has tied up $10,000 for six months for a 10% profit, when he could have made at least that much every week or so by moving on to better trades. There was no compelling reason to think the stock would go up soon, and the trader had no exit plan.

What should you do?

1)Take small losses.
2)Realize you don't need to win on every trade.
3)Don’t fall in love with the trades you make.
Buying What’s "Hot"Many traders make trades because of public opinion, not because the trade itself makes sense. When a particular market trend seems popular, many investors rush in so they don’t feel they’ve missed an opportunity. The result is that many investors will buy at a price point where the trade can’t possibly work out favorably.

Avoid the emotion of what’s "hot." Successful traders notice when emotion affects trading, and create plans to take advantage of the emotional trades of others.

Here’s an example of what not to do: Let's say you've been following a particular stock which is in a "hot" sector, and it just announced a stock split. The stock is now at 18, and you calculate it could get to 25 or more by the time of the split. The market is currently bullish, and it looks like a great trade.

The problem is that the stock has been rising for the past four days. It started at 12, but you didn't notice it until it hit 18 — a 50 percent increase — and it's still rising. The stock split is a month away, and you know it's likely to fall in price somewhat between now and the split. Still, everyone is talking about this stock, and what if it just continues to rise and becomes the next blockbuster stock? You’re afraid if you don’t make a trade you’ll miss a great opportunity. (And besides, you want to be able to tell people that you hold a position in this stock, because it makes you seem smart.)

So you buy 1,000 shares at $18.50.

During the next two weeks, the stock goes to 19, then levels off, loses momentum, and drifts down to 17. Then a couple of leading NASDAQ companies give earnings warnings, the market drops, and the stock slides to 15, triggering the stop you'd set at 16 on half your holdings. The stock trades in that range for a week, and then begins to rise slightly going into the split. Your plan is to sell a day or two after the split. The stock rises a little beyond $20.50 by the second day after the split, and then the volume dries up and you sell it for a $2 profit. But since you stopped out of half your shares at 16, you lost $2.50 per share on that half, with a net loss of .50 on 500 shares.

What went wrong?

What went wrong was that you didn't let the stock come to you. Instead, you chased it as its price rose, knowing perfectly well that — following the stock split trend — it would probably pull back before running up again.

You knew that it was more likely to pull back than it was to continue on an uninterrupted run to 25, and you knew that if you bought at 18 or higher you were probably paying too much. You disregarded what you knew was more probable in favor of what might happen — even if there was only a very small chance of that unlikely thing happening. You should have given the stock a chance to come to you, at a price you felt was reasonable. If the stock had pulled a surprise and never gotten down to where you thought it would, that would be okay — there were many other stocks to trade, and some of them would have come down to your price. You didn't have to own this particular stock.

What was the right way to play this particular scenario?

When the market is bullish, it's very likely for a stock to rise when a split is announced, drift down after a few days' rally, and then begin to rise again a week or so before the split. If that's the trend and there's no solid reason to think the stock will rise immediately, wait a few days for the stock to drift down and stabilize before buying it. If you had done so in this case, you could have bought it at $16.50 and then sold it for $20.50 for a $4.00 profit on the entire 1,000 shares. If you had a solid reason to think the stock might continue to rally, you could have bought half the total number of shares you wanted at a price that might have turned out to be too high, and waited for a lower price to buy the other half. If it had turned out to be too high, it would only have reduced your profit. (No stock goes up or down in a straight line. Wait for a pullback before buying.)

Envying Others Some traders spend a lot of energy focusing on what other traders do. They become concerned that everyone else is making 30% a week on their portfolio, that everybody else finds great trades that they miss, and that everybody else knows what they're doing while they don't. This leads traders to try to copy what others are doing, making those trades too late, and making trades that aren't good ideas in the first place. They get so confused trying to keep track of so many stocks that they don't understand what's going on with any of them.

Many traders don't realize that a lot of what people say is at the very least an exaggeration.

Similar to envy is competitiveness. Some traders want to show everyone that they're the best, the smartest, the most successful. The goal of trading isn’t to play a competitive game – it’s to make money. Your focus should be on making money. If you're in it for the competition, you should play some other game. The only reason to trade is to make money, and if your mind is on an imaginary competition that only you care about, you'll never make money.

Successful traders ignore hype, rumors, and boasting, and use their own knowledge and judgment to find trades that make sense and that they have confidence in. This doesn't ignoring the current public sentiment, because that sentiment can sometimes lead to good trading opportunities. Successful traders know what is reasonable to expect from trading, and how to achieve it without worrying about what everyone else is doing.

Victims of Success

Some traders become victims of their own successes. They have good “luck” with a certain type of commodity, for instance, that they overexpose their portfolio to one sector.

Sectors tend to move together, and often one sector will move down as another one moves up. Sectors are cyclical, which means that they go through hot and cold phases. No one commodity or type of commodity is hot all the time, and when a leading commodity in a sector gets into trouble, it tends to bring all the rest down with it.

Here’s an example: A trader bought gold futures just as a huge metals sector run was beginning. He bought silver and platinum as well, and to do so closed out all of his other positions, which had been in stocks and currencies.

The trouble was that, two days later, concerns about global terrorism lessened, and the metals sector fell sharply.

Diversification is important even for short-term traders. Some market moves can't be protected against, and if all your holdings are in one or a few sectors, you become vulnerable and exposed to excessive risk.

Laziness and Inattention


Lazy traders are certain to become losing traders. Inattentive traders neglect to research and monitor their positions and markets, so they don’t have a good sense of what strategy to employ. Lazy traders don’t have a concrete plan, and trading without a plan is one of the surest ways to lose in any market.

The lazy trader might buy a stock because he sees that it's been going up steadily for a week and a half. He doesn't know why, but he does know the experts say it’s a "strong" stock. He buys it in the morning, it goes up a few percentage points, and he assumes he’s made a winning trade.
To his surprise, the stock does a falls in the afternoon and starts going down as steadily as it went up in the morning. The lazy trader can't figure out what went wrong. Why did it fall? If he'd simply bothered to check the earnings calendar, he'd have seen that the company was scheduled to report earnings that day after the market closed. The steady run-up was in anticipation of the earnings announcement, and now traders were taking profits and getting out of the stock in case of a negative reaction to the earnings results.

What should you do?


1)Know why a position is moving.
2)Know why you're buying into the position.
3)Check basic information on the position.
4)Once you're in the position, watch the market, check for news, and monitor the position’s behavior throughout the day.
5)Know what events are coming so you can anticipate changes in the position’s direction.

Emotional Stress


Here, the rule is simple: If you're sick, emotional, or can’t properly focus due to outside events, don't trade. Take a break.

The reason is simple. If you trade when you're not feeling well, physically or emotionally, you won't trade well. You'll just lose money. At the very least, you'll be too distracted to trade successfully.

Knowing when not to trade is an important form of discipline you must learn. This discipline is also necessary on days when the market is so directionless and choppy that no trade is going to go anywhere. But the main point here is to be in good enough touch with your emotions that you can recognize when you’ll be unable to focus properly. In any case, it's healthy to get away from the market for a day or two, or even a few weeks, from time to time. The time away will help you regain perspective about what things in life really matter. And if you need to trade every day, it may be a sign of an unhealthy addiction.

Which Pitfalls Are Hindering Your Success?

If you want to improve as a trader, you must identify the mistakes you make consistently so that you can recognize your own pitfalls. To do this, look back at ten losing trades you've made in the last few weeks. Can you find similarities? Look closely and be completely honest with yourself. Part of being a good trader is being able to look at things with a clear eye and seeing what's really there, not what you wish was there.

Now here's the harder part: Look back at your recent successful trades and find the ones that succeeded only by luck. How would they have turned out if you hadn't been lucky? What were your mistakes with those trades?

Identify the two most common mistakes you make. Identify your most disastrous trades and identify the mistakes you made with them.

From now on, you must keep your psychological and emotional soft spots in mind at all times while you're trading.

Your goal as a trader should not be to trade perfectly all the time, to win on every trade, or to be perfect in any other way. Putting too much pressure on your self to be perfect is one of the best ways to make lots of mistakes. Besides the fact that no one can be perfect, there's also the fact that you don't need to be perfect. You can make amazing amounts of money in the markets by being a good, consistent trader.

As a trader, you'll be richly rewarded if you do your job consistently and well. You'll be doing far better than 99 percent of the other people trading stocks in the market, not to mention money managers, analysts, and other so-called "experts."

Instead of perfection, your goal should be to control the emotional barriers to your success.

Long-term trading success is achieved through consistency: consistently taking small losses and larger profits, consistently rejecting trades that are too risky or that aren't based on good reasoning, and consistently doing what you know is right instead of acting against your better judgment. Consistency is a discipline, and it will serve you well in life as well as in trading.

The purpose of identifying your psychological soft spots is not to make you feel like you're a poor trader. All traders, even the best, have weaknesses — they just recognize and control those weaknesses. Instead, the purpose of getting to know your personal pitfalls is to develop a realistic sense of your strengths and weaknesses so that you can recognize mistakes before they happen. Being realistic — about yourself and about the market and the trades you make — is the way to succeed as a trader.

"What Takes Some Successful Traders A Lifetime To Achieve Could Take You Just A Few Days... Or Less!"

HOME
Advertorial 1 - Introduction
Advertorial 2 - The Basics of Analysis and Rational Trading
Advertorial 3 - Basic Principles
Advertorial 4 - Characteristics of Successful Traders
Advertorial 5 - Playing to Your Strenghts, Overcoming Your Weaknesses
Advertorial 6 - Winning Psychology
Advertorial 7 - Avoiding Common Pitfalls
Advertorial 8 - Sound Money Management
Advertorial 9 - Trading Systems
Advertorial 10 - Final Words