The New Year is a time of change for many people. For investors it is frequently a time when many decide to get more active and devote some of their capital to trading, rather than investing in a more passive manner. However, the sad fact is that by about half way through the year most of those who make that decision will have lost their money.
The exact percentage of retail traders that fail is hard to know, but studies show anywhere between seventy and ninety percent of the time, day traders lose money in any given period. The obvious advice to give, therefore, is not to do it at all, but many still will, and for those, following three simple rules will increase the chances of surviving long enough to learn the often very expensive lessons that will set you up for long-term success.
Rule #1: Have a Strategy: It is important to have a plan going into a trade. No matter how good your analysis and how rational you usually are, once you open a position and your money is at stake, the stress does strange things to your way of thinking. Taking a loss becomes harder, and taking even a tiny profit looks very attractive. If you give in to that, your losses are always much bigger than your profits, and simple logic dictates that that is not a recipe for success.
Logical, unbiased analysis is much easier before you have money at stake. It is therefore far better to set a strategy for each trade going in. A simple bracket with a stop loss and a profit target can be easily set at the time of executing a trade on most platforms and gives you a framework from which to run a position.
The key is to focus on exits rather than entries. No matter how strongly you may feel about something, don’t enter a trade unless the chart suggests at least a logical stop-loss level that is close enough to result in a manageable loss should things go wrong.
It is, of course, not just enough to set a logical stop and profit level, you also have to stick to them, and that leads us to rule number two…
Rule #2: Never Average a Loser: When I started out in a forex dealing room back in the 80’s, my first boss told me early that “Only losers average losers.” When you set your initial stop-loss order it should be based on a level that is likely to provide support, but the problem with that is that when you are losing money and you get to that level, it is easy to convince yourself that rather than being a level that, if broken, demands that you cut your losses you see it as a good opportunity to buy some more and improve your average.
Let’s say you bought at 80 with a stop-loss set just below a support level at 40. When you get to forty and bounce a bit, buying more there to improve your average to 60 can look very attractive, but here’s the problem. The very fact that you got down there suggests that your initial analysis was wrong, so why compound a mistake?
Sometimes it will work and you can get out at 60, but taking losses on some trades and cutting flat on others is, once again, not very smart.
The worst thing about averaging losing positions, though, is that it often leads to the big blowout that kills your account. In my experience, those that do it frequently do it again when the first average goes wrong, and again, and again. Before long what started out as an ordinary, risk controlled trade becomes a do or die situation, but when it does you are already behind massively, and cutting is not an option. Long-term success in trading is more about avoiding big losses than making big profits, and averaging losers leads to big losses.
Rule #3: Don't Fall in Love with a “System”: We are, I guess, all lazy at heart. In new traders that laziness shows in their desire to find some magic system for trading. You know the kind of thing, if “A and B happen, and the date is the square root of the price time ten, it’s a good buy” or some such garbage.
The unfortunate fact is that there is no substitute for hard work. Analyzing a stock, commodity or whatever, whether based on fundamentals or some basic, easy to follow chart patterns, is the only real way to increase your odds of a winning trade. Remember, if a pattern is so obscure that only a few people see it, it isn’t a pattern, it’s a coincidence.
There is of course no guarantee that if you follow these three rules you will make money trading. That will ultimately depend on which trades you take, but if you have a plan, never average a loser and don’t fall in love with a system you will at least avoid the most frequent mistakes of those new to trading and give yourself a fighting chance. Good luck!
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.